Calculating How Much Working Capital Your Small Business Needs

Assessing your working capital needs as a small business owner isn’t always easy to do, and working capital is more than just having more assets or money over expenses. To analyze how much money you need, you’ll need to focus on many details, and since your business is different from any other, it’s always best to have an independent financial advisor help you to make your financial needs better known.

Prepare for the Worst

One of the first things for small business owners to do is to determine what the worst case scenario looks like. It’s always necessary to prepare for what could happen even if it’s unlikely to happen. By doing this, it helps small businesses – who often face some of the most financially difficult parts of opening and running a business – avoid failure. Some, like Nicole Snow at Darn Good Yarn, call this a “financial stress test.”

What to Assess

In order to know how much working capital your business needs, you need to analyze details about your company including:

  • Your company’s current growth rate
  • The industry you are in (and how fast it is growing)
  • The life cycle that your business is in
  • What opportunities are available for the company

For example, if your business is no longer a startup but has deeper roots, your answer to how much capital you need is going to be different than a brand new company. However, in nearly all situations, small businesses anticipating taking on more working capital, including debt or equity, are generally doing so because they hope to expand.

Get Numbers on Paper

A good place to start is with an analysis of your current operating cycle. Your operating cycle includes your inventory, your accounts payable, and your accounts receivable. Your accounts receivable details needs to be based on the number of days it takes to collect on that account and accounts payable on the number of days you have to pay the bill.

Can your small business finance your operating cycle? That is, can you pay your bills month in and month out without any extra financial contribution? If there is a shortfall present, this indicates that your profits are not as high as they should be and working capital may need to increase to meet the demand. Your small business is not alone in this. Many business owners of all sizes need short-term working capital boosts from time to time. It’s quite common for example, to need a boost in working capital at seasonal boosts so that you can purchase inventory in preparation.

Look Long Term

While short-term working capital options may be acceptable to some situations, they are not solutions for longer term or ongoing struggles related to capital needs. To analyze this information, again, sit down and do some calculations.

  • What do you anticipate your expenses to be over the course of the next year?
  • What are your fixed expenses currently and expected over the next year?
  • What variable expenses are likely to occur (again, think worst case scenario here)?
  • What amount do you need to feel financially safe within your business?

Having a cushion is generally the hard part for most business owners. How much should they have available if the industry takes a nosedive or the local economy faces financial difficulties? It’s impossible to place a specific dollar figure on this for small businesses since every business’s needs – even those in the same industry – will be different. Ultimately, you need to determine how much extra you need to feel as though you company has the financial means available to weather the roughest of storms over a period of three to six months.

Review Your Assumptions

Another important step in determining what your working capital needs are is to look at the assumptions you are making about your business.

  • Are you anticipating or assuming your customer base will grow with your expansion?
  • Are you assuming your new product is going to be something all of your customers desire?
  • If you are opening a new location, you may have on paper what the fixed costs are going to be, based on your existing location. However, you don’t know how long it will take for you to get customers in the door at that location to meet the fixed costs.

Of course, making decisions about working capital isn’t easy. You do not want to take on more debt than your business can handle because it will cut into your company’s profits. Be as realistic as possible when it comes to projections about your business. Set conservative, moderate and even optimistic projections and plan for them all. And, create a business plan that clearly outlines every situation in detail, giving your potential lenders clear information about what could happen and what your specific goals are.