How to Measure Your Working Capital Requirements

Having enough working capital on your balance sheet can mean the difference between long-term business success and failure, making it important to measure your liquidity requirements regularly. Working capital, which is calculated by subtracting your current assets from your current liabilities, needs to counterbalance fluctuations in your operating expenses, sales, cost of goods sold and supply chain, while helping compensate for unforeseen costs such as litigation. Otherwise, you run the risk of closing up shop permanently.

Operating Expenses

While there are standardized working capital calculators that take into account enterprise-level performance metrics to measure your liquidity needs, you can also look at your income statement and forecast variances in your operating expenses to get a sense of your working capital requirements. Prepare a trend analysis that illustrates trends for rent, fixtures, utilities and professional services, just to name a few expenses. You can also prepare your income statement in the multi-step format and perform horizontal analyses, which can provide a much better sense of the liquidity needs your business will have in the short-term.

Sales Fluctuations

Your sales impact everything from profit margins to your ability to generate cash flows to pay your obligations as they become due. If you anticipate seasonal fluctuations in sales based on year-over-year trends, you can increase your liquidity to compensate for the decrease in cash flow. If your company and its products are struggling to compete against cheaper goods or new products, then you can boost your working capital while you develop a plan to increase your sales.

Cost of Goods Sold (COGS)

Your cost of goods sold, including direct labor, direct materials and miscellaneous overhead expenses, can drastically impact your working capital requirements. Changes in direct labor costs attributable to labor strikes, temporary labor and pay raises can increase your payables and your need for cash. Similarly, increases in raw materials prices and obsolete or damaged inventory can boost your liquidity needs. Measure these fluctuations and adjust your COGS budget accordingly.

Supply Chain Fluctuations

Vendors and vendor contracts can change, impacting the overall efficiency of your supply chain and the costs realized by you and your customers. If there are disruptions in the flow of raw materials within your supply chain, you can end-up losing sales and experience a decrease in cash flow, requiring you to have working capital on-hand to make payroll and keep the lights on. Also, if you decide to change vendors and the quality of the goods or services you source turn out to be poor, your sales and cash flows can suffer, increasing your need for working capital.

Litigation

Litigation can drain a company of its liquidity and cause all sorts of long-term complications, especially for start-ups or small businesses struggling just to survive. You can gauge the potential for litigation given your industry and operating environment, then calculate the cost of legal expenses and adjust your working capital requirements accordingly. While this is a subjective assessment, a well-researched analysis and expense forecast can mitigate the risk of lawsuits bankrupting your company. Contingent liabilities associated with litigation also provide a measure of your working capital requirements.

There is no reason to forfeit all of the hard work you’ve put into your business because of a working capital deficiency. Measuring and monitoring your liquid assets on a regular basis will help you hedge against risks in the marketplace.