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.
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.
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: