Working capital is fuel to a business which keeps it in motion. It is cash in hand that a business requires to maintain procedures running smoothly. In technical words, it highlights the discrepancy between the significance of existing acquisitions and current liabilities.
Working capital is the reflection of a company’s operational efficiency. When the value of current assets is more than the value of current liabilities, a business has positive working capital, meaning the company will not face any roadblocks in meeting financial obligations.
If you have just started a business or are looking to start a business, you will have to ensure that you will always have some cash in hand to keep the ball rolling. Some people believe that the profits that arise after sales will be utilised, so there is nothing to worry about.
Do not forget that you will hit the profitable stage only after reaching the breakeven point, and your business needs cash to run right from the day of set-up.
How much money will you need as working capital for your business?
This is what everybody wants to know who has just started a business. With some savings and working capital loans for small businesses with bad credit, people start their businesses with the hope that soon they will start making profits and everything will automatically be on track.
Do not forget that your revenues will be partially used to pay all of your liabilities, and there is no guarantee that you will start making profits within the expected period. This causes worries among young entrepreneurs, and therefore try to know the size of working capital they need.
No one can answer this question straightaway, as multiple factors determine the size of the working capital of a business.
Business Type
Certain types of businesses require dramatically high working capital in comparison to others. Businesses which require physical inventory, including manufacturers who need raw materials to manufacture products and wholesalers and retailers who keep produced inventory in-house to sell when customers make an order, will need very high working capital.
Apart from them, seasonal businesses also need high working capital. Such companies include grocery stores that have to start keeping stock for the coming season to fulfil customers’ demands. However, some businesses that offer consultation services need very little working capital. Likewise, established companies that are not expecting to grow rapidly do not need very high working capital.
Operation cycle
The operation cycle plays a bigger role in deciding your business’s working capital. Ideally, a business can pay off short-term debts from the revenues made from sales, but it is decided by the operating cycle. A long operating cycle can make it impossible for a business.
If you take a long time to sell a product to your customers, you will need some money in the reservoir to meet your financial obligations. Likewise, companies with high account receivables need high working capital as payment is yet to be received through the sale.
Management goals
The goals of your business will also decide how much money you will need as working capital. For instance, if you have decided to expand your business, you will certainly need higher working capital until it comes on track. This is particularly true for businesses that want to enter a new product line. You will need to spend on research, development, design, and the like.
How do you calculate working capital?
To calculate working capital, you need to deduct current liabilities from current assets. You can get the value of both current assets and current liabilities on a company’s balance sheet. Current assets include business properties you can liquidate next year, and current liabilities include short-term financial obligations to be paid off within one year.
What does affect working capital?
Many factors affect the value of working capital, but the most common factors include receivables and liabilities. Debtors have an instant effect on your working capital. You cannot afford to give a lot of time to your debtors to collect payments because otherwise, you will end up suffering from negative working capital.
Further, if you do not get paid by your debtors, you will struggle to make payments to creditors on time, which means penalties over penalties.
To balance this situation, you should shorten the collection cycle and lengthen the payables cycle. If you allow your debtors a week to pay you and avail of two weeks from your creditors, you will be able to retain some cash that you can use in your operations.
Working capital problems do not arise in businesses that accept upfront payments from their customers. If your business does not allow it, you should still ensure that the receivable cycle does not stretch over.
Here are other ways to improve working capital:
- Avoid financing fixed assets with working capital.
- Perform credit checks on new customers to avoid the risk of defaults
- Cut unnecessary expenses
- Whittle down debt
The takeaway
Working capital is the sum of money you need to meet the day-to-day operations of your business.
- You can find the value of your company’s working capital by subtracting the value of current liabilities from current assets.
- A current asset is anything in your business you can turn into cash within a year, and current liability is a financial obligation to be met within a year.
- When current assets are lower than current liabilities, working capital is negative, a deplorable business state.
- It is not so easy to determine the size of working capital because it depends on management goals, business type, and operation cycle.
- You can improve working capital by shortening the receivable cycle and extending the payment cycle, cutting unnecessary expenses, reducing reliance on debt, etc.
