TABLE OF CONTENTS
- What Is Working Capital?
- How to Calculate Working Capital
- What Are the Factors of Working Capital Management?
- How Much Working Capital Does a Business Need?
- How Much Working Capital Is Needed to Build Your Business?
- How to Fund Additional Working Capital Needs
As a business owner, determining your working capital needs is an important management responsibility.
Knowing your minimum working capital requirement gives you a target to maintain and a basis for growing your business.
What Is Working Capital?
Working capital is a measure of a business’s liquidity. It’s important because it indicates the ability of a business to pay its bills and meet its debt obligations on time.
Companies with insufficient working capital will fall behind on paying their bills. Therefore, it’s important for a business owner to continuously monitor their working capital and make any adjustments needed to keep it at a comfortable level.
How to Calculate Working Capital
You can calculate working capital in 2 ways: as net working capital or as a ratio
Net working capital is defined as current assets minus current liabilities. Current assets are assets that you expect to convert to cash within one year. Current liabilities are debts that must be paid within one year, such as short-term loans, accrued expenses and accounts payable to vendors.
For example, if your business has $300,000 in current assets and $200,000 in current liabilities, your working capital would be $100,000 ($300,000 less $200,000).
To find your working capital ratio, also known as the current ratio, you would divide current assets by current liabilities.
In our example, the working capital ratio would be 1.5 to 1 ($300,000 divided by $200,000). This means you would have $1.50 in current assets for each $1 in current liabilities.
What Are the Factors of Working Capital Management?
There are a number of factors that affect the amount of working capital a business should maintain.
Type of Business
Some businesses require more working capital than others. Compare, for example, a fast-food restaurant to a wholesaler. The restaurant buys food and beverages to use within a week or so, and its customers pay immediately. A wholesaler, on the other hand, must maintain a high inventory level with hundreds or thousands of products and sell to its customers on credit terms.
The restaurant will have much lower requirements for working capital than the wholesaler that has to carry inventory and accounts receivable.
Working capital requirements for seasonal businesses will increase during periods of high demand and decline during the off-season.
In this matter, consider the length of time. If your business involves manufacturing, the working capital cycle begins when you purchase raw materials and ends when you collect the cash from your customers after the sale of finished products.
If you’re facing stiff competition, you may have to extend more liberal credit terms to attract and maintain customers. You also might have to keep more goods in inventory to satisfy customer demands. In both cases, your increase in working capital requirements will be higher because your accounts receivable and inventory will be higher.
Vendor Credit Availability
If your vendors are able to offer you longer payment terms, say 60 to 90 days instead of 15 days, your working capital needs will be less.
More efficient operations will require less working capital. Less efficiently run businesses have more money tied up in stale or unsold inventory and unpaid accounts receivables, which slows down their cash flow.
Companies that are able to maintain low inventory levels and high turnover rates will have lower requirements for working capital.
Scale of Operation
Higher levels of sales will require proportionally higher levels of working capital.
How Much Working Capital Does a Business Need?
The purpose of calculating working capital needs is to determine how much you require and to maintain that level. Let’s use the working capital ratio as a benchmark.
A comfortable working capital ratio is from 1.2 to 2 to 1. If your ratio is less than 1 to 1, you’d likely have difficulty paying operating expenses and meeting debt obligations. You’d owe more in current liabilities than you’d have in current assets, creating negative working capital. Anything above 1.5 to 1 will give you more flexibility.
Here’s an example: Suppose you have a widget manufacturing company that has $1,000,000 in annual sales, and you sell to your customers on 45-day terms. The company makes a gross profit margin of 40%, and your suppliers sell to you on 30-day terms, which finances the raw materials representing ½ of the cost of goods sold.
Your average accounts receivable outstanding will be $125,000 ($1,000,000 times 45 days divided by 360 days). Your accounts receivable turnover is 8 times per year ($1,000,000 annual sales divided by $125,000 average receivables outstanding).
It takes 30 days to make the widgets, and the finished products remain in inventory for another 30 days, for a total of 60 days. The average inventory level is $100,000 ($600,000 cost of goods sold times 60 days divided by 360 days). This means your inventory turns over 6 times per year ($600,000 cost of goods sold divided by $100,000 average inventory).
Suppose your average monthly operating expenses are $25,000. A good rule of thumb is to keep 3 to 6 months of your monthly operating expenses in cash. So let’s go with 3 months or $75,000 to keep in cash. Although, as a business owner, you should keep whatever level of cash in your bank account makes you feel comfortable.
If your suppliers are giving you 30-day terms, this means your average accounts payable will be $25,000 ($300,000 in materials costs divided by 12 for 30-day terms).
Summing up, current assets total $300,000 ($100,000 plus $125,000 plus $75,000) and current liabilities are $25,000 from suppliers. If the target working capital ratio is 1.5 to 1, you can handle up to another $175,000 in short-term loans and current liabilities ($300,000 divided by $200,000 equals 1.5) and stay at or above your target ratio.
In this example, your working capital is $100,000 ($300,000 in current assets minus $200,000 in current liabilities).
How Much Working Capital Is Needed to Build Your Business?
Now suppose you want to increase your revenue by 30% to $1.3 million. And you plan on gaining those sales by extending your credit terms to customers and adding to your product line. How much working capital will you need to support this growth?
As a result of extending your credit terms, your receivables increase to 60 days outstanding and an average balance of $216,667 ($1,300,000 times 60 days divided by 360).
In this case, the cost of goods sold would be $780,000 ($1,300,000 times 60%). Adding to your product line increased your average inventory level to $125,000.
Monthly operating expenses would also rise, but not necessarily by 30%; so let’s project a 20% increase to $30,000 per month. This means cash balances would rise to $90,000 ($30,000 times 3 months).
In total, current assets add up to $431,667 ($90,000 in cash plus $216,667 in receivables plus $125,000 in inventory). Maintaining the working capital ratio at 1.5 to 1 sets current liabilities at $287,778 ($431,667 divided by 1.5).
Your projected working capital at the increased sales level is $143,889, an increase of $43,889 from a sales level of $1 million dollars.
How to Fund Additional Working Capital Needs
You can fund your additional working capital needs by:
- Retaining profits – If your profit margin is high enough, you may be able to finance your growth by retaining profits in the business rather than increasing salaries or issuing dividends.
- Increasing equity – You can avoid increasing your debt load by adding more equity to your business.
- Using a revolving line of credit – A revolving line of credit can make up short-term deficits and cash flow and working capital.
- Borrowing against receivables – Factoring or discounting your invoices will shorten your cash flow cycle and increase your working capital.
- Financing inventory – Lenders will make advances against your inventory to finance growth.
- Refinancing fixed assets – If you have fixed assets that are paid off, you can borrow against these assets and add the funds to short-term working capital needs.