Activity Ratios in Operating Working Capital

Businesses need to maintain a minimum amount of cash to fund their day-to-day operations.  This is called the company’s working capital.

In the next video, our faculty will explain the concept of operating working capital in detail.

Note: Here it is assumed that there are 360 operational days in the year.

In the video, you learnt that the operating working capital is the amount of money required to fund a company’s operating cycle. It can be calculated by using the following formula:

$Operatingworkingcapital=Inventory+Accountsreceivable-Accountspayable$

Following are the drivers of working capital:

• Inventory

• Customer credit

• Supplier credit

You also learnt about the operating working capital ratio:

• $Workingcapitalratio=\frac{Workingcapital}{Salesrevenue}X100$

• A measure to benchmark the performance of a company against that of other companies of different sizes

In order to understand the drivers of working capital, you need to calculate the activity ratios of a company. Following are the activity ratios:

• Days sales outstanding (DSO)

  • Days sales outstanding (DSO) = $\frac{Accountsreceivables}{Salesrevenueperday}$

    • Sales revenue per day = $\frac{Salesrevenue}{360}$

  • This measure represents the accounts receivable in terms of sales revenue per pay

• Days payable outstanding (DPO) 

  • Days payable outstanding (DPO) = $\frac{AccountsPayables}{Costofgoodssoldperday}$

    • Cost of goods sold per day = $\frac{Costofgoodssold}{360}$

  • This measure represents the accounts payable in terms of the cost of goods sold per day. It shows how fast the payment to the supplier is made after delivery of the cost of goods sold. 

• Days inventory outstanding (DIO)

  • Days inventory outstanding (DIO) = $\frac{Inventory}{Costofgoodssoldperday}$

  • This measure calculates the days of inventory that represents the days of cost of goods sold.

In the next segment, you will see how changing one driver of working capital will impact the overall working capital requirement of a company.