No business can survive without sufficient working capital. It ensures sufficient liquidity to help you cover day-to-day business expenses. What exactly is working capital? Generally speaking, it is the difference between current assets and current liabilities.

• Current assets include accounts receivables, inventories and other cash-convertible assets.
• Current liabilities include accounts payables, short-term loans and obligations that are due within a year.

When current assets are greater than current liabilities, it is called positive working capital. In case of a reverse scenario, it is called a negative working capital. Most of the entrepreneurs know the definition of working capital, but they do not know how to calculate how much they actually need.

Just because you have a positive working capital, it does not imply that your business does not need greater working capital than this. Insufficient working capital will prompt you to take out working capital loans for a small business.

Calculating working capital precisely requires more than taking a view at your balance sheet. You need to comprehend the cash cycle, industry norms, and growth plans.

What are the steps to precisely calculate how much working capital your business needs?

The following steps can help you to calculate how much working capital your business needs:

• Step 1: Understand your operating cycle

An operating cycle, in other words, is called a cash conversion cycle. It measures how long it takes to turn receivables and inventories into cash. The following formula is used to calculate a cash conversion cycle.

Operating cycle = days inventory outstanding + days sales outstanding – days payables outstanding

• Days Inventory Outstanding means the time taken to sell inventory.
• Days Sales Outstanding means the time taken to collect receivables.
• Days Payables Outstanding means the time taken to pay suppliers.

You will need a large amount of working capital to bridge the gap between accounts payable and accounts receivables if the operating cycle is long.

• Step 2: Analyse the previous data

You cannot figure out the aforementioned information without reviewing your past financial statements. They will help you understand the trends to know the average collection period, inventory turnover rate, supplier payment terms and seasonal fluctuations.

It is vital to peruse the previous reports as they will also inform you of time periods when you faced cash shortage problems.

• Step 3: Take into account growth plans

It is worth keeping in mind that working requirements can never be static. For instance, when you branch out to a new market, or you launch a new product, you will need additional cash to make it happen, but otherwise your demand for working capital will not be that much higher. You will need to calculate the amount of working capital from time to time.

• Step 4: Calculate the working capital requirement

Add receivables and inventory together, and then deduct the payable amount from the total sum. If you find that your business may not be able to have that much working capital, you should try to consider invoice finance for small businesses in the UK.

This will help you finance accounts receivables before payments are due, and you can use this money to meet day-to-day business operations.

• Step 5: Adjust for industry trends

You will also have to take account of industry trends. Whether you will have a positive or negative working capital, it also depends on the type of business you run. For instance, the retail industry often experiences negative working capital because suppliers are paid later and customers pay upfront.

However, it does not have to be a sign of a problem for retail businesses. It is rather a strength as it is like funding your business operations with suppliers’ credit without tying up your own cash.

Similarly, if you are in a manufacturing business, you will need a great amount of working capital. You should compare your current and quick ratios against industry averages as well. This is essential to have realistic figures.

• Step 6: Build a safety cushion

There is always a scope of contingencies. Customers might delay in making payments, or any unexpected expenditure can cause disruptions. You should always have a buffer of at least 20% to cushion the blow of contingencies.

What are the tips to optimize working capital?

To manage working capital, you should:

• Accelerate collection from your customers. Try reducing the billing cycle from 60 days to 30 days, for example. The sooner you receive cash, the better it is. Send payment reminders to speed up collection and charge late payment fees to deter defaults.
• Negotiate better terms with your suppliers. You should collect payments from your customers before payments are due to your creditors.
• Try to reduce business operations. Outsource functions without compromising on quality. Prefer digital alternatives to cut down paper costs to perform administration tasks.

If you still need money to fund working capital, you can take out a business loan, but it is recommended that you carefully calculate the total cost of it. A business loan calculator can help you know the estimated cost and choose an affordable deal.

To wrap up

You will have to plan in order to estimate how much working capital you need. Understand your business cycle, needs, growth trajectory, etc.

If you need some help, consult a business advisor. Make sure they know your industry trends inside out.

FAQs

1. Why is working capital important?

Working capital is important because it helps you meet day-to-day operations. You cannot keep running your business without sufficient working capital.

2. Is it good to have a high working capital?

It is good if you have enough liquidity to cover your business expenses. Too high working capital may indicate that your assets are sitting idle.

3. What is an ideal working capital ratio?

An ideal working capital ratio is between 1.5 and 2.0. Below 1 indicates your liabilities exceed assets, and above 2 implies that excessive cash is tied up.

4. Can a business survive with negative working capital?

Yes. Some business from retail sectors can survive where customers pay upfront, but businesses in manufacturing industries can face financial stress.

5. How often should I reassess working capital?

Every quarter or whenever you experience a significant change in sales, growth plans and supplier terms.