BUS103: Introduction to Financial Accounting

Working capital is commonly defined as the funds a business needs to support its normal operations. In some ways, a working capital analysis is similar to a cash flow forecast, but it differs in its focus on the operating cycle of the business.

Quoting from the website Entrepreneur.com, "the operating cycle analyzes the accounts receivable, inventory and accounts payable cycles in terms of days. In other words, accounts receivable are analyzed by the average number of days it takes to collect an account. Inventory is analyzed by the average number of days it takes to turn over the sale of a product (from the point it comes in your door to the point it is converted to cash or an account receivable). Accounts payable are analyzed by the average number of days it takes to pay a supplier invoice.

"Most businesses cannot finance the operating cycle (accounts receivable days + inventory days) with accounts payable financing alone. Consequently, working capital financing is needed. This shortfall is typically covered by the net profits generated internally or by externally borrowed funds or by a combination of the two.

"Most businesses need short-term working capital loans at some point in their operations. For instance, retailers must find working capital to fund seasonal inventory buildup between September and November for Christmas sales. But even a business that is not seasonal occasionally experiences peak months when orders are unusually high. This creates a need for working capital to fund the resulting inventory and accounts receivable buildup". A working capital analysis is prepared in a manner similar to what we described for a cash flow forecast in that assumptions are made about the impact on working capital as a result of activities during the forecast period in order to provide the business owner with assurance that adequate working capital to support operations will be generated by normal business operations. If not, alternative sources of working capital must be lined up, and the earlier such a need is recognized, the better.

Break-even analysis

A break even analysis is designed to show you how much revenue must be generated to cover your fixed and variable costs. Revenue below the breakeven point means the business is losing money and revenue above the breakeven point means the business is profitable.

Let us look at a simple example, one that assumes your business is selling only one product. In order to calculate the breakeven point you will need to know three things:

• Your fixed costs
• Your variable cost
• Your unit selling price
  

Once the breakeven point is passed and revenue continues to rise, your business will be profitable. This is why knowing your breakeven point in terms of unit sales is so important. The website About.com:Entrepreneurs contains an easy to understand formula for calculating your breakeven point:

To conduct your breakeven analysis, take your fixed costs, divided by your price minus your variable costs. As an equation, this is defined as:

Breakeven Point = Fixed Costs/(Unit Selling Price - Variable Costs)

This calculation will let you know how many units of a product you will need to sell to break even. Once you have reached that point, you have recovered all costs associated with producing your product (both variable and fixed).

Above the breakeven point, every additional unit sold increases profit by the amount of the unit contribution margin, which is defined as the amount each unit contributes to covering fixed costs and increasing profits. As an equation, this is defined as:

Unit Contribution Margin = Sales Price - Variable Costs

Recording this information in a spreadsheet will allow you to easily make adjustments as costs change over time, as well as play with different price options and easily calculate the resulting breakeven point. You could use a program such as Excel's Goal Seek, if you wanted to give yourself a goal of a certain profit, say USD 1 million, and then work backwards to see how many units you would need to sell to hit that number.