The amount of working capital a small business owner needs to operate and grow depends on the type of business, the operating cycle, and the business’s goals.
What is Business Working Capital?
Working capital is the difference between the current assets and liabilities of a company. A business’s current liabilities refer to the costs and expenses a company incurs within 12 months. Current assets include things the business owns that can turn into cash within the same time frame.
Current asset examples:
- Checking and savings accounts
Marketable securities (example: stocks and bonds)
- Business inventory
- Account receivables
Current liability examples:
- Materials and supplies that need to be purchased
- Short-term debt payments
- Rent
- Utilities
- Interest
Tax payments
If a business has more current liabilities than current assets, they have negative working capital. Without the ability to raise cash quickly, a business with negative working capital will not stay on top of its business expenses. A business with higher working capital can operate comfortably to meet operating expenses.
Factors That Determine Working Capital
Type of Business
A business’s product or service will depend on how much much working capital it needs. A business with physical products (manufactures, wholesalers, retailers) typically needs more working capital than a company that sells an intangible service (staffing, consultants). A business with seasonal fluctuations will need higher working capital before and during their busy season to prepare.
Operating Cycle
The operating cycle of a business is the time it takes a business to receive inventory, sell the inventory, and collect cash from the sale. It analyzes accounts payables, accounts receivables, and inventory. Ideal business planning would allow a company to pay its debts with cash from the sale of its inventory. However, if the business has a long term operating cycle, this could be impossible.
Businesses that take a longer time to create and sell a product will need more working capital to fulfill day to day operations. Also, companies that bill customers for goods instead of requiring payment upfront will need higher working capital.
Business Goals
Specific business goals will also determine how much working capital a company will need. A business will need long term working capital if they are new and looking to grow. In contrast, a small business that wants to stay small will need a smaller amount of working capital to operate and cover cash flow.
Calculate How Much Working Capital Your Small Business Needs
It’s important to understand the working capital cycle of your business. This means determining how money goes through your company. The working capital cycle, also referred to as turnover rates, consists of how quickly your current assets, such as accounts receivable and inventory are turning into cash. Then how quickly that cash is used to pay the current liabilities, such as accounts payable.
To forecast how much working capital your business needs, you must analyze your business turnover rates using income statements and balance sheets. You analyze turnover rates by finding this specific information:
- Inventory turnover: How many days of inventory is needed to be kept on hand?
- Accounts receivable turnover: How long does it take a customer to pay an invoice?
Accounts payable turnover: How long does it take me to pay vendors?
As stated above, working capital needs are based on business goals and growth plans. Growing a business requires larger inventory and higher accounts receivable, alongside more working capital. To calculate how much working capital you need, you must create a projected income statement with predicted sales and cost of goods sold. Your new working capital amount is the change in accounts receivables plus inventory, less accounts payable.
Accounts Receivable Financing Improves Working Capital
One of the best ways for small businesses to improve their working capital is through accounts receivable financing. Invoice financing provides a business with immediate cash for their unpaid invoices, giving them access to the working capital usually tied up. It is a great solution to help businesses maintain cash flow and operate as usual.
A business owner sells its outstanding invoices to the factor at a discount to receive funding. No additional debt is incurred as there is no loan to pay back like with credit cards or traditional banks.
If you’re looking to improve your working capital, get access to our cash flow, and grow your business, get in touch with us today. Porter Capital has provided over $6 Billion in funding to clients across the nation. Learn more here.
