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# What is the Formula for Creditor Days?

## Creditor Days = Creditors / Average daily purchases = Creditors / (Purchases / 365)

Creditors is given in the Balance Sheet and is normally under the heading Trade Creditors or
Accounts Payable.
Purchases is found in the Profit and Loss Account. Purchases is the total of cost of sales and
How is Creditor days calculated in practice?
1. Purchases from the Profit and Loss Statement
Revenue 440,000
Cost of sales 176,000
Gross profit 264,000
EBITDA 129,000
Depreciation 65,000
Interest 20,000
Profit before tax 44,000
Tax 9,000
Profit after tax 35,000
2. Creditors from the Balance Sheet
Property 300,000
Other fixed assets 90,000
Fixed assets 390,000
Cash 5,000
Other debtors 30,000
Stock 20,000
Current assets 150,000
Other creditors 30,000
Current liabilities 100,000
Working Capital 50,000
Bank overdraft 20,000
Bank loans 120,000
Other loans 70,000
Borrowings 210,000
Net assets 230,000

Capital 60,000
Retained profits 170,000
Owners Equity 230,000
In the example above the cost of sales is 176,000 and overheads are 135,000 giving total
purchases 311,000, and trade creditors are 70,000. The creditor days ratio is given by using
the formula Creditor Days Ratio = Creditors / (Purchases / 365) = 70,000 / (311,000 / 365) = 82
days. It takes the business on average 82 days to pay its suppliers.
In the above example it is assumed that Other Creditors does not relate to purchases, for
example it might relate to deposits or deferred income, and it is therefore excluded from the
calculation.
If you are using purchases for a different period then replace the 365 with the number of days in
the management accounting period.
If using monthly (30 days) management accounts
Monthly purchases 18,000 and month end creditors 19,000 then
Creditor Days Ratio = 40,000 / (20,000 / 30) = 60 days
What does the Creditor Days Ratio show?
If your Creditor Days are increasing beyond your suppliers normal trading terms it indicates that
the business is not paying its suppliers as efficiently as it should be. For example if your normal
terms are 30 days and your Creditor Days ratio is 60 days the business on average is taking
twice as long to pay suppliers as it should do.
Any downward trend in the Creditor Days ratio means that an increasing amount of cash
(possibly from overdrafts) is needed to finance the business, this can be a major problem for an
Useful tips for using Creditor Days
The Creditor Days should be the same as your Terms of Trade with suppliers. If the creditor
days ratio is continually higher it means the business is paying its suppliers late which could
eventually lead to supply problems. If the creditor days ratio is trending lower than the normal
terms of trade it could indicate that suppliers are being paid too early, reducing the amount of
cash available in the business, or it might possibly be due to early settlement discounts being
taken from suppliers.
A cash business should have a much lower Creditor Days figure than a non-cash business.
Typical ranges for Creditor Days for a non-cash business would be 30-60 days.
What is Working Capital
Working capital management is the set of activities that are required to run day to day operations
of the business to ensure that cash is adequate to meet short term debt and upcoming
operational expenses. Working Capital is also known as circulating capital or revolving capital.
Working Capital is a measure of companys operational efficiency, liquidity and short-term
solvency.

Working capital is defined in terms of Net Working capital, i.e, Current assets - Current liabilities.

Working Capital Ratio refers to how much capital a company should maintain to achieve zero or
possibly lower risk in conducting its daily operational activities.

In order to better understand working capital management, lets understand Current Assets and
Current Liabilities. Current assets are those short-term assets that can be converted into cash
easily and current liabilities are those liabilities, which are due in near future generally, within a
year.

Working Capital Formula
The Working capital formula can be understood with the help of the following:

According to the Balance Sheet:
Net Working capital = Current Assets Current Liabilities (excess of current assets over current
liabilities, also known as net current assets)

As per Operating Cycle / Working Capital Cycle:

A companys operating cycle or working capital cycle typically consists of the following activities:
1. Purchases for business
2. Produces the product (Inventory)
3. Sells the product (Receivables)
4. Collect Money

Thus, Operating cycle or working capital cycle is nothing but the period taken by the business to
convert cash (paid for purchases) back to the cash (received from selling the goods). It is also
known as circulating capital because current assets of the firm are changed from one form to
another, in an ordinary course of business.

Thus, when the firm refers to negative working capital they are basically referring to shortage of
current assets to meet current liabilities.

Working Capital Management Ratios

Working Capital Ratio 1: Current assets / Current liabilities

This is also known as the Current Ratio. This ratio tells us whether the company has adequate
short-term assets to cover its short term liabilities. Ratio below 1 indicates negative working
capital. If the ratio is around 2 it is considered satisfactory.

Example:

Current assets = \$ 250,000
Current liabilities = \$ 150,000
Working capital Ratio = \$ 250,000/ \$ 150,000 = 1.67

In this example, working capital ratio of 1.67 indicates that current liabilities are secured by 1.67
times of the business current assets and it shows a health liquidity position. Working capital ratio
above 2 indicates underutilized assets and bad working capital management. Working capital
ratio less than 1 indicates that the firms current assets are not capable of meeting its short term
liabilities and that the business is in Jeopardy. In that case, its known as negative working capital
(excess of current liabilities over current assets)

Working Capital Ratio 2 - Inventory Conversion period: Average Inventory / Cost of
sales/365

This indicates the average time to convert inventory into sales. Inventory is not sold as it is
manufactured. Thus stocking of inventory involves cost. Inventory conversion period represents
the efficiency of the companys working capital management in holding the goods. They should
not overstock and pay higher maintenance costs and at the same time, they should maintain
enough stock so as to meet demands.

Less conversion period is better because the inventories are converted faster into sales. This
working capital ratio is very important for companies who deal in perishable stocks like food
industry. Greater the time it takes to sell the goods higher is the risk of obsolescence.

Example:
Opening Inventory = \$ 50,000
Closing Inventory = \$ 80,000
Cost of Goods Sold = \$ 400,000
Average Inventory = (50,000+80,000)/2 = 65,000
Therefore, ICP = 65,000/400,000/365 = approximately 60 days

Thus, it takes 60 days for a company to convert its inventory into sales.

Working Capital Ratio 3 - Receivable Conversion period: Average Receivables / Net Credit
sales/365

It is also known as average collection period. It represents how quickly the debtors can be
converted into cash during the period. In other words, it represents the average time between the
sale of the goods on credit and cash receipts of the same.

A fundamental concept of time value of the money is money received today is better than money
to be received in future.

Cash sales are always better as the money comes to you today itself, however, business may
have to provide credit period to his debtors so as to increase its turnover, thus it involves an
opportunity cost and of course default risk but at the reward of increasing sales.

Example:
Opening Receivables = \$ 20,000
Closing Receivables = \$ 25,000
Credit Sales = \$. 500,000
Returns = \$ 20,000
Average Receivables = (20,000+250,00)/2 = 22,500
Net Credit Sales = 500,000 20,000 = 480,000
Therefore, ACP = 22,500/480,000/365 = approximately 17 days

It means cash is received on an average within 17 days of the credit sales. This can be
compared with normal credit policies of the business, which is generally laid down in the notes to
financial statements of the companies. Say if the credit policies specified is more than 17 days,
it represents the efficient collection management system and vice versa.

Working Capital Ratio 4 - Payable Turnover Ratio: Net Credit Purchases/Average Payables

It indicates the speed with which the payment is made to the supplier for the credit purchase
during the period. If this working capital ratio is declining over the period, it may signal worsening
financial condition.

Example:
Average Payables = \$ 50,000
Net Credit Purchases = \$ 350,000
Payable Turnover Ratio = 350,000/50,000 = 7 times

To calculate the average number of days unpaid during the period, the Payable Turnover Ratio
is divided by 365 days, i.e, 365/7 = 52 days. Therefore, on average the company
repays amount to its creditors after 52 days of the credit purchases.

Thus Operating cycle is Inventory conversion period + average collection period average
payment period

In this case = 60 + 17 52 = 25 days

Thus, it takes 25 days for the business to convert the cash back to cash. Operating cycle is
continuous and not discrete.

Working Capital Management Case Study. Lets review a real life example of HUL
Hindustan Unilever Limited (Consolidated)

Working Capital Ratios Year 2013 Year 2012
Current Ratio 0.78 0.86
Quick Ratio 0.47 0.47
Inventory Turnover Ratio 9.98 10.02
Debtors Turnover Ratio 29.14 25.78
Working Capital Days -26.61 -17.29

Working Capital Case Study Analysis
Current Ratio has decreased from 0.86 to 0.78 and Ratio is below 1 which indicates that the
current assets are inadequate to meet its short term liabilities and it does not in favor healthy
short term financial condition.

It is to be noted that though current ratio has decreased, quick ratio is intact. It implies that the
decrease in current ratio is because of inventories {Quick ratio is nothing but (Current assets
Inventories Prepaid Expenses)/Current liabilities}

For 2013
Average conversion period = 365/9.98 = 37 days
Average collection period = 365/29.14 = 13 days
Average Payment period = 37 + 13 X = -27 days, i.e, 77 days

For 2012
Average conversion period = 365/10.02 = 36 days
Average collection period = 365/25.78 = 14 days
Average Payment period = 36 + 14 X = -17 days, i.e, 67 days

From the above figures, it can be seen that there is no significant change in conversion and
collection period, however working capital has increased from -17 days to -27 days, which I
relate to increase in average payment period from 67 days to now 77 days, which is again not in
the favor of the company.

Working Capital Management Strategies
Working capital management directly affects the firms long term growth and survival. A company
may be profitable and it may have sufficient assets, but short of liquidity may endanger its
goodwill.

Management should make sure that they have adequate working capital so as to manage its
daily activities and upcoming operational expenses. There is high risk and uncertainty involved in
managing the working capital since your debtors may not pay you at the time when you have to
pay to your suppliers. At the same time, management cannot keep excess capital as it leads to
opportunity loss of the excess capital blocked and shortage of it can lead to irreparable damage
to the company in terms of lost suppliers due to delay in payments or lost customers due to not
meeting the demands as and when required which may also result in poor returns, high amount
of bad debts and low market value of shares.

Effective working capital management allows the company to invest in future growth, repay its
current liabilities as and when they become due and reduce financing costs. Thus, working
capital management will involve managing cash, inventories, receivable and short term financing.

Cash Management
Management needs to identify the cash balance required for the smooth functioning of the daily
activities of the business but at the same time also reduces cash holding costs.

Inventory Management
Management needs to identify the level of inventory which will allow smooth production but at the
same time also reduces ordering and carrying costs. Inventories should not be over produced as
well so as to lower management costs.

Management resorts to practices like Just in time and Economic order quantity for efficient
Inventory Management purposes.

Debtors Management
Management should identify the appropriate credit policy which will attract the sales such that
any impact on the cash flows will be offset by higher sales.

Short Term Financing
Management should also identify the appropriate source of financing. They should also compare
the interest rate paid on borrowings with Return on capital so as to take correct financing and
investment decisions

Sources of Working Capital
1. Own Funds
2. Bank Borrowings
3. Sundry Creditors
4. Advance from customers
5. Deposits due in a year
6. Pre received Income
7. Other Current Liabilities

Working capital management is more critical for those industries which seek higher liquidity for
their daily operational activities or by nature whose operating cycle is higher - such as technology
firms because goods take time to produce and it is reasonable to expect these firms to have a
large value of inventories with long production processes.

Financial Analysts manage and optimize working capital without compromising on the companys
potential sales and profits. The Analyst should forecast the amount required to acquire fixed
assets and meet working capital needs and can carry out sensitivity analysis and assess the
severity of underinvestment due to negative working capital. It may also be possible that at point
of time the short term solvency of the company is not good but that does not mean that it is a bad
management or bad investment. For eg. If company today is not able to pay their supplier that
does not mean it will not pay in future. In such cases, the analyst will have to look at the true
picture of the financial conditions, quality of management and make their own judgements. They
should implement processes and systems to evaluate inventory productivity, minimize costs and
maximize working capital.