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One of the most common questions that bankers are asked is: “How big of a line of credit am I eligible for”? For many small to medium sized businesses, having quick access to working capital through a line of credit is essential to help ride the waves of cash flow. However, many businesses do not know where to start when figuring out the actual working capital and line of credit needs.
Not knowing your working capital needs when applying for a line of credit can cause issues as a business grows. If a line of credit is too small, a company can be hamstrung by not having the necessary working capital to grow. If a line of credit is too large, a company can get deeper in debt than they should, causing cash flow problems in the future.
Fortunately, there is a simple calculation that exists that can help a business figure out their true working capital needs. This calculation is called the Cash Conversion Cycle and shows how much working capital/cash it takes from the time a company buys inventory to the time that inventory is sold, invoiced, and then paid for. The Cash Conversion Cycle simply lets a business know how many days from purchasing inventory to collecting payment it takes. With this information in hand, it is easy to discern an average working capital need.
Cash Conversion Cycle (CCC) = Days Inventory Outstanding (DIO) + Days Sales/Receivables Outstanding (DSO) – Days Payables Outstanding (DPO).
For Example, if a company has DIO of 12, a DSO of 35, and a DPO of 15 the CCC would equal 32. Knowing that the CCC is 32 a business can look at its average sales figure to get a working capital/cash need.
Net Revenue – Net Income – Non-Cash Expenses = Annual Cash Spend (ACS)
ACS/365= Daily Cash Spend (DCS)
DCS x CCC = Working Capital Needs.
To continue this example. A company with $1,200,000 in sales, a profit of $300,000, and non-cash expenses of $10,000 would have ACS of $890,000 and a DCS of $2,438. With a CCC of 32 the working capital need is approximately $78,000.
Being armed with this information, a business can be certain that they are applying for a line of credit that meets their needs. Alternatively, if this all sounds like a foreign language, a PyraMax Banker (or your CPA) will be able to assist with this calculation. Working with a banker that understands the unique cash flow needs of your business will ensure that you have the tools at your disposal to accelerate your growth.