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Get into gear

By Silverman Consultants CEO Bob Epstein for Southern Jewelry News [ December 2007 ]

Riding a bike is a little like owning a retail business—there are going to be strenuous uphills, glorious downhills and everything in between. How you handle the ride is based on your ability to keep the wheels moving by judiciously pedaling, and knowing when to shift gears quickly and skillfully.

Imagine your retail business is composed of two large wheels, much like a bicycle. As a retailer, the bicycle you ride is called the working capital cycle. Its two wheels are called the sales wheel and the working capital wheel.

The working capital cycle can get you where you want to go. To get there, and remain in control of your destination, you have to understand the basic components.

Understanding Working Capital

Working capital can be defined as what's left after you subtract current liabilities (debts owed within a year) from current assets. Current assets are principally cash, inventory, accounts receivable, and other assets that convert to cash within a year.

The working capital cycle is the way your business continually generates cash, by selling inventory, then uses that cash to cover operating expenses and purchase additional inventory. The key concept underlying the working capital wheel is that cash flows in a circular path. Being able to precisely calculate your exact amount of working capital at any given moment can be useful in some instances, such as when you are about to place a big order. However, for the purposes of this discussion, it's much more important to understand the circular nature of your working capital resources, and how to manage them most effectively.

Remember—it isn’t the amount of cash you have at the end of the day that counts, but rather the flow of cash into, through, and out of your business that keeps you going!

Spinning Off Cash

Theoretically, the faster the working capital wheel turns, the more profit is generated for every dollar invested in your retail business. For example, if you made one dollar every time the wheel turned, and then found a way to turn that wheel three times as fast, you'd earn three times as much. When someone talks about "spinning off cash," they are referring to this process.

Visualize sales as a wheel connecting with the working capital wheel. Every time a sale is made, the sales wheel turns with the working capital wheel, and a little bit of your inventory is converted into cash or a receivable (which eventually converts to cash). As the wheels continue to turn, part of this cash is re-invested into more inventory. The rest "spins off" to cover operating expenses, taxes, and, if all goes well, profit.

There are two ways to increase the speed of your working capital wheel. One is to increase the size of the wheel driving it—increase your sales. The other is to decrease the size of the working capital wheel by reducing inventory or accounts receivable, while maintaining constant sales. The optimum goal, of course, is a combination of the two. 

In any case, learning to manage, predict, and control the components of the cycle are the secrets of reaching your destination.

How To Shift Gears

All retailers constantly strive to sell more products.  However, there are times when it just isn't possible to increase sales. Does that mean you should toss up your hands in despair? No! As we learned above, there is another approach to increasing your store's profit.

Inventory, accounts receivable, gross margin, and expenses—these are four areas in which you can exercise some degree of control. If your working capital wheel isn't turning properly, you may need to shift gears. Your wheel is signaling one or more of the following road conditions.

  • Too Much Inventory

Do you calculate turnover regularly (every month) to maintain your preferred balance of stock in relation to sales? Inventory turnover is figured by dividing your annual sales by your average inventory at retail, or by dividing your annual cost of goods sold by your average  inventory at cost.  The average turn in the jewelry industry is 1.3x.  If your turns are below your industry average, you may have excess inventory.

Excess inventory costs you in interest expenses, in storage costs or in damaged merchandise. Ideally, by monitoring your turnover, you should be able to maintain your present level of sales while carrying less inventory.

  • Accounts Receivable Difficulties

Is too high a percentage of your sales tied up in receivables? Do you have an excess of old or delinquent accounts? Study your billing system to make sure that 1) it's efficient, and 2) it's being executed properly.

Perhaps now is the time to establish more stringent credit requirements, or to crack down on those past-due customers. Perhaps you need to computerize your accounts receivable.

  • Inadequate Gross Margin

Gross margin is what's left of sales revenue after you deduct the cost of the merchandise. Many retailers assume that if they beat last year's sales volume they are on an ever-brighter path. Not so.

You cannot afford to inflate your sales volume by deflating your gross margin percentage unless you are creating adequate gross margin dollars.  Obviously, you don't want to price yourself out of the market, but your gross margin must be sufficient to sustain your store. Do not consistently offer "sale" merchandise at reduced gross margins without careful consideration.

  • Expenses Too High

Many expenses involved in operating a store, such as your rent, utilities, insurance, and administrative wages, are not controllable. But there are expenses you can and do control.  As the store owner or manager, you must choose how much to spend on sales commissions, advertising, even the merchandise itself.

Monitor each of your variable expenses by calculating them as a percentage of sales. For example, if your advertising last year totaled $5,000, and your sales for the year were $100,000, your advertising was 5 percent of your sales ($5,000 ÷ $100,000 = 5 percent). Let's say this figure is up several percentage points from the previous year, and sales have not increased accordingly. You may decide that your promotional expenses should be reduced during the current year.

Calculating your expenses as a percentage of sales, both monthly and yearly, is a good way to keep them in line. 

Working Capital—How Much Is Enough?

One way to tell whether you have adequate working capital is simply to see whether you are able to meet all your current obligations within the agreed-upon terms. It's advisable, however, to plan a bit more carefully.

The two ratios that reflect whether you have adequate working capital are the quick ratio and the current ratio.   Calculate your current ratio by dividing your current assets by your current liabilities (current liabilities are obligations due within one year). The current ratio measures how much money is available in liquid assets to meet short-term obligations. 

If you have a current ratio of 1.6 to 1, then for every dollar in liabilities due within a year, you have $1.60 of cash plus accounts receivable plus inventory.

Adequate working capital varies from operation to operation.  But $2 of current assets for $1 of current liabilities is generally safe.

The quick ratio is calculated by dividing cash plus accounts receivable by current liabilities. Though similar to the current ratio, the quick ratio relies on only the most liquid assets, and is therefore a stricter test of solvency. 

If you have a quick ratio of 0.6 to 1, then for every dollar of liabilities you have, $0.60 is available in cash and accounts receivable.

How do your store‘s ratios compare? Remember that your bicycle is driven by the rear wheel. The back wheel is the working capital wheel and it will help you generate new sales. Too often, business people think that more sales will increase their business. Creating cash is one thing; keeping it and using it to your advantage is another.

Ideally, you will get to where you want to go without pedaling too hard. That's when both wheels are working equally and you’ve found the right gear. Then you can coast—with the wind at your back and cash where you need it.

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Silverman Consultants CEO Bob EpsteinBob Epstein is CEO of Silverman Jewelers Consultants. Since 1945, Silverman has been considered one of the premier sales consulting firms to the jewelry industry, specializing in improving cash flow and maximizing the recovery on distressed inventory through professionally conducted sale events. Bob can be reached at 800-347-1500 or by e-mail at bob@silvermanconsultants.com.