Updated August 10, 2022
Capital is extremely important for any company. Without enough capital, the business won’t be able to grow or move forward.
Over time, you want to be able to take your company from a small startup and turn it into something big. That takes capital — and it also takes a good understanding of how capital works, so you can make the right choices for your business. There are two different types of capital: growth capital and working capital, and it’s working capital that will be addressed here.
What Is Working Capital?
The simplest explanation of working capital is that it’s the money your company needs to operate, covering basic expenses like employee payroll and inventory. You may also need to carry accounts receivable because you’ve billed people who haven’t paid those bills yet.
Until that money comes in, you don’t want to be broke. Some companies use a credit line for their working capital, but it’s not always easy to obtain one of those. You need to be able to show how you will pay the credit line back, generally over one operating cycle (a year). If you don’t have enough cash flow (liquidity), you may not be able to get a credit line to pay your working capital expenses.
You can assess your working capital by figuring out its ratio. Divide your assets by your liabilities, and that will tell you whether you can use short-term assets to pay short-term debt for the business. Your assets need to be higher than the liabilities you have, because that means your cash flow is positive. A ratio of 1:1, for example, means your assets and your liabilities are equal. You can pay your bills, but you’re not making any money.
If your working capital ratio is negative, you’re paying out too much in relation to what you’re bringing in. That is not sustainable and can put you right out of business. If you can correct it, you can keep the business going and even turn it into something profitable, but if you keep having a negative working capital ratio, you will eventually have to close up. You need enough working capital to pay your bills and have money left over that you can put into savings or invest back into the business.
It may seem counter-intuitive, but you also do not want your working capital ratio to be too high. A ratio of more than 2:1 means that you have a lot of money coming in, but you are holding onto it and not investing it back into your business.
Short-term assets are great, but you need plenty of longer-term assets, as well. Without a good balance between the two asset groups, your company’s financial stability could be at risk. If you need a lower working capital ratio you can collect on the accounts receivable you have, take a bit longer to pay your bills, and cut down on your inventory. Keeping your ratio above 1.2 and under 2 makes you a lot more attractive to creditors, and that can help keep your business alive.
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.
While there are standardized working capital calculators that take into account enloanterprise-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.
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 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.
How Much Working Capital Do You Really Need?
It’s easy for a new business owner to get confused about the level of working capital they really need. Part of the reason that happens is that there is a misunderstanding about working capital and growth capital. These are not the same, but if they are treated the same way by a business owner, it’s possible to severely damage the financial health of your company.
You need enough working capital to avoid having to cut into your growth capital to fund basic business needs. If working capital should be paying for something, but you have to use growth capital instead, you may have a negative working capital ratio — and not enough growth capital to help your business develop.
If you plan to expand your company, consider doing it in stages instead of all at once. If you try to expand too quickly, it’s easy to use up all of your working capital and put yourself into real financial trouble. Fortunately, you can avoid that cash-poor position by moving a little more slowly so you can realize your company’s dreams without running out of the working capital you need. With a good working capital ratio and smart business decisions, your company can be ready to expand and develop organically, so you can have the maximum amount of success.
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