Edge Retail Academy Blog

Importance of Working Capital Management

In all industries, and especially in retail jewelry, efficient Working Capital is essential. Working Capital is defined as the difference between Current Assets and Current Liabilities.

One measurement of a company’s health is the Current Ratio, or Ratio of Current Assets to Current Liabilities. For example, if your balance sheet shows total Current Assets including cash of $30,000 and total Current Liabilities including current portions of long term debt of $15,000, then your Current Ratio is 2:1. Bankers look to this ratio as an indication of balance sheet liquidity, assuming that the conversion of current assets to cash can be used to repay Current Liabilities. Therefore, Current Assets in excess of Current Liabilities has the appearance of liquidity. Balance sheet liquidity is considered insufficient at less than 1:1, adequate between 1:1 and 2:1, and very liquid over 2:1.

The management of a Company’s primary Working Capital accounts of Inventory, Accounts Receivable (A/R) and Accounts Payable (A/P) is required to ensure sufficient cash to meet operating and debt requirements. A Company’s minimum Working Capital requirement is defined as A/R – plus Inventory – less A/P. With an Inventory of $1,000,000, A/R of $50,000 and A/P of $250,000, minimum Working Capital required would be $800,000.

Well-known “Super Stores” benefit from negative Working Capital with no Accounts Receivable, as all sales are done on a cash basis. Inventory is “just in time” – requiring vendors to maintain goods for delivery on demand to various store locations – and then extend Accounts Payable terms for these goods. Negative Working Capital allows for the accumulation of cash from sales and minimum cash tied up in Inventory due to the trade payment terms. These Super Stores have the power of demand over the vendors, because vendors want to sell goods to them.

Independent businesses need to balance funding their Working Capital accounts, with the cash needed to repay short term obligations, such as rent, payroll, debt servicing, and other operating expenses. Optimal Working Capital management ensures having sufficient cash to continue operations and satisfy short-term debt obligations.

For independent retail jewelry companies, Inventory is not often converted to cash at the same rate that short term liabilities are due. Aged or overstocked Inventory is responsible for a lack of liquidity including cash necessary to repay obligations.

Unlike other industries. that keep only enough inventory on shelves for short- term demand, most jewelers feel the need to offer many styles, sizes and price points while mixing fashion items and staples. A reasonable test is to compare the value of Inventory to the Cost of Goods Sold in a twelve-month period. Inventory levels exceeding twelve months of COGS implies that in-store stock is sufficient to supply an entire year’s worth of sales or more; therefore, no longer a “liquid asset”. For example, inventory of $1,000,000 and 12 month COGS of $500,000 implies 2 years of inventory on the shelves. Inventory of $1,000,000 and 12 month COGS of $2,000,000 implies 6 months of inventory on the shelves.

It is vital for the health of independent companies, for those companies to manage their inventory levels, which in turn prevents borrowing excessively to support Working Capital needs.

A better test for jewelry retailers is to use the “Quick Ratio” which is similar to the Current Ratio but excludes Inventory from the equation. Anything better than a 1:1 Quick Ratio will show that the business has the ability to repay short-term obligations. When planning this over time, a business can see if this ratio reveals improving or declining liquidity; then owners can take corrective action thereby employing Working Capital Management.

For help determining your Optimum Inventory level, or for strategies to clear aged Inventory, generate cash, and improve Working Capital ratios, contact Becka Johnson Kibby, 714-925-2456, at Edge Retail Academy.

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