Working capital is often one of the most difficult concepts in the financial world to completely understand. It is especially problematic for small businesses who do not have armies of accountants to quickly analyze and provide crucial decision-making advice. However, it is entirely possible for a small business owner to calculate and anticipate their working capital needs.
What Exactly Is Working Capital?
Working capital is defined as the amount of money in which your current assets exceed current liabilities (Working Capital = Current Assets – Current Liabilities). If you think this equation is less than helpful in determining your working capital needs, you are correct. You can run this equation every day and still not arrive at how to adequately determine your working capital needs.
How Do You Calculate Working Capital?
A more useful method of determining working capital is to focus on your small business’s operating cycle. The operating cycle analyzes your business’s inventory, accounts receivable, and accounts payable in terms of days. Breaking the operating cycle down, this means that inventory is analyzed by how many days it takes to turn your inventory into a sale (either cash or accounts receivable). Accounts receivables are then calculated in terms of how many days it takes to fully collect on the account.
Finally, accounts payable are analyzed by the number of days it takes to pay any given supplier’s invoice. Overall, an average number of days for inventory, accounts receivable, and accounts payable should be calculated.
What Does it All Mean?
To fully appreciate these numbers, we need to consider the broader picture of the operating cycle in a small business setting. Most small businesses cannot finance the cost of their operating cycles with the net 30 or net 60 accounts payable financing typically provided by vendors. In a perfect world, your operating cycle (average number of days for inventory + average number of days for accounts receivable) should equal or be less than the number of days given for accounts payable financing.
Unfortunately, the perfect world doesn’t exist for most small businesses and working capital infusion is needed to ensure they can pay their suppliers on time to keep their operating cycle churning along without any unneeded hang-ups from vendors. The shortfall created by the disparity in time between deadlines for accounts payable and the average time of your operating cycle can be covered by internally generated net profits, borrowing funds, or a combination of these two options. The better option is to set aside net profits if at all possible.
If your business sees an influx in sales during the Christmas holidays, you might need short-term working capital to cover the extra inventory to ensure you have enough product on hand to cover the demand. Even if your business is not affected by the holidays, it would be wise to analyze your orders monthly to determine if you experience months where demand is unusually high. Any months with higher inventory demands are going to create a need for additional working capital to cover accounts receivable and fund the larger inventory orders.
The key takeaway from this article is to plan ahead for your business. Getting caught off guard will likely negatively affect your business’s bottom line. If you are running a new business and do not have enough net profits to set aside, consider equity funding, establishing good relationships with trade creditors, factor crediting, establishing a line of credit at a bank, or applying for a short-term loan to cover your working capital needs.