Determining the amount of working capital you require is an integral part of getting your business off the ground.
For existing small businesses, maintaining working capital is a smart way to lower risk. The amount of working capital your small business needs will depend on the type of inventory you keep and your operating cycle.
What Is Working Capital?
Working capital represents the amount of cash available to cover your business’s short-term expenses, such as advertising costs and employee salaries. Specifically, it refers to the liquidity required for the next year ahead.
It can be calculated in a technical sense as the difference between current assets and current liabilities. Once each of these amounts are calculated, you can determine the working capital you need.
Your company’s current assets include the cash amount that can be converted in the short term — typically, inventory.
Current liabilities are the expenses your company is responsible for paying within the next 12 months, such as loan repayments.
Why You Need Working Capital
The idea behind having working capital in your business is to safeguard operations with a cushion of liquidity, or spare cash. Here are the major benefits of having working capital on hand:
Keep Your Inventory Stocked
Being able to keep a full inventory status allows you to reach higher sales potentials. If you don’t have working capital available to spend, you don’t have to wait for your inventory to sell out before restocking.
Cover Unexpected Vendor Payments
If one of your vendors suddenly has a sale and it makes sense for you to stock up on extra inventory in advance, you save money in the long run by having cash on hand to make the purchase. Smart purchasing decisions are crucial in a business’s earliest stages, and having plenty of working capital can help you make the best financial choices possible.
Plan for Unpredictable Sales
Small businesses should always be prepared for erratic sales performance. Changes in demand or vendor supply can throw you for an unexpected turn, and having working capital keeps you operating and gives you the chance to recover.
Fund Your Growth Strategy
If your business is brand new and needs to show positive sales growth, having sufficient working capital is imperative for fueling that growth. You’ll need to cover advertising, pay your marketing and sales teams and make time for media coverage.
How Much Working Capital Does a Business Need?
Every business has its own requirements for working capital depending on its unique operational timeline that determines its “working capital cycle.” Your working capital cycle refers to the timespan your business needs to turn over inventory and receive payment from customers. To ensure your cash flow stays positive, calculate the minimal working capital needed at all times.
How to Determine How Much Working Capital is Needed
The exact amount of working capital you need can only be estimated based on the data you have. That said, you can still arrive at an educated estimation using the right calculation.
1. Calculate Your Current Assets
Current assets include cash, accounts receivable, inventory and other assets that are expected to be liquidated within a year. Check your balance sheet and add up the total value of your current assets.
2. Add Up Your Current Liabilities
Your current liabilities include rent, utilities, taxes, employee salaries and payments to vendors and creditors owed within the next year. Look at your expense sheet and determine the short-term spending you did last year or on average in the past few years.
3. Subtract the Difference Between Assets and Liabilities
Find your required working capital with this formula:
Working capital = (current assets) – (current liabilities)
For instance, if you have a sum of $100,000 in assets and $75,000 in liabilities, the working capital you need is $25,000. In other words, it takes an estimated $25,000 for you to maintain operations within the next year.
If you go below $25,000 you risk experiencing a negative cash flow.
Factors that Affect Working Capital Needs
The money you need as working capital depends on the type of business you run and the way your cash flow timelines play out. Here are the major factors that determine whether your business needs more or less working capital than average:
Your Operating Cycle
Your operating cycle is the time it takes for the cash you invest into operations to return to your account as a result of sales. Companies selling perishable food or other time-sensitive goods naturally have shorter operating cycles, which typically causes them to require less working capital to function. Companies with longer operating cycles see as much as a year pass between the time of acquiring inventory and receiving the cash from its sales.
If your company is a brand new startup, you need a great deal of positive growth early on to see success. This requires funding to invest in marketing, advertising and innovation. You might be expanding your location or updating your technology to meet long-term goals, and require short-term working capital to make the dream happen. Determine the costs of investing in your growth and add it to your liabilities when you calculate working capital needs.
How Much Working Capital Does a Startup Really Need?
The working capital your business needs should reflect the difference between your line of credit and the cash you have coming, to ensure there’s a safety net of space between them. If you’re a solopreneur with a startup and no sales history data to inform financial decisions, you may be wondering: How much working capital do I need?
You or your accountant can calculate your working capital requirements based on prospective assets and impending liabilities. Since you don’t know how long it will take for your inventory to sell and convert to cash you can use, it’s important to plan for the maximum amount you can expect your company to need on hand. With your operational funding accounted for annually, you have cushion and time to react if results aren’t as planned.
Strategies for growth, such as expanding your production or entering a new market, will inevitably require additional working capital.
How to Generate Ongoing Working Capital
Raising the amount of working capital you need requires you to first calculate it, then plan for it. Here’s a breakdown of the steps you should take:
1. Set Your Goals for Growth
Set measurable goals for growth, such as expanding to a new location, rolling out a new product or seeing a specific increase in sales. Depending on the growth you want to see in your current operating cycle, you’ll require a different amount of capital to cover expenses.
For example, seeing more sales will require more spending on advertising. On the other hand, the goal to update the technology your staff uses, will require a different investment. Doing your research on the costs to meet your goals is a key part of calculating the working capital you need.
2. Take Out a Line of Credit
Having a company credit card in your arsenal can give you short-term cash when you need a safety net. Once you know the amount of credit you’re eligible for, you can better determine your short-term budget available for spending on advertising and operations.
If you fall short of funding required to operate and advertise, your growth will slow and financial problems can snowball. That’s why it’s better to have a longer line of credit than you need, as opposed to not having enough.
3. Allow Room for Change
Calculate the working capital to keep your business open or to see it grow, and then add additional funds to it. The extra working capital is to account for any unexpected costs that may come up.
For example, unanticipated legal fees, equipment failures or theft-related losses. Take at least five percent of your working capital amount and add the dollar amount to your working capital for cushion. Whether you need to spend less cash, raise more or both, it’s important to have a little more than just what you need to get by.
4. Spend Your Working Capital
Spend your working capital by wisely re-investing it into your business. While extra working capital is never a bad thing, you still want to spend most of it because working capital fuels growth.
When you’re investing in advertising, marketing and sales or in expanding your product line, the money comes back to you. In turn, this creates more working capital, which can fuel your next stage of growth. Particularly if you’ve taken out a business loan, it’s important to generate cash flow from it as soon as you can by spending the loan on your business investments.
The Working Capital Needs of a Growing Small Business
Strategic growth in your business means understanding the working capital required to meet your growth goals, and raising it.
Whereas larger companies can fall back on larger credit lines, small businesses need to keep income and expenses balanced in a way that favors upward growth.