Have you ever wondered how much working capital your business needs? (Or even, perhaps, what exactly “working capital” means?)
The question most commonly pops to mind when you’re facing a cash flow crunch and starting to fret about whether you’ll have enough money to pay your bills and cover payroll in the current month. If you’re short, you start to think that your business probably needs more working capital, and you start to research business loans or lines of credit. On the flip side, if you’re able to cover your expenses, you must have enough working capital, right?
Maybe, maybe not. Whether you have enough cash to cover your expenses in the current month is only part of the answer of how much working capital your business needs.
Chief Financial Officers, financial strategists and other financial professionals use a more comprehensive process to determine how much working capital a company needs. Let’s take a closer look at this broader, more technical definition of working capital and how it’s calculated. Not only will you understand how to correctly determine how much working capital your business needs, you’ll know when you need to secure a business loan or line of credit.
The True Definition of “Working Capital”
As mentioned above, the amount of working capital your business needs goes beyond having enough cash to pay your current monthly expenses. That’s just the beginning.
Financial professionals consider “working capital” to be the “difference between your company’s current assets and its current liabilities.” An asset is cash or anything that could be converted into cash within a month to pay liabilities, such as accounts receivables and inventory. Current liabilities are your expenses and bills that are due within the current month. Liabilities include accounts payable and the current month’s installment on any outstanding loans or leases. If you have credit card bills, a mortgage for your office, any equipment leases or vehicle loans, tally them up as liabilities.
How Much Working Capital Do You HAVE?
Now that you have your total assets and total liabilities, you can start to calculate your working capital needs by figuring how much working capital you have right now. Let’s imagine that your business has $1 million in current assets and $750,000 in current liabilities. We subtract current liabilities ($750,000) from current assets ($1 million), which gives you a positive amount of $250,000 in working capital.
Unfortunately, many businesses – maybe even yours – aren’t in the position of having positive working capital. Let’s imagine again that your company has only $300,000 in current assets, but $400,000 in current liabilities. Yikes! You’re coming up short and have negative working capital totaling $100,000, which means that covering your monthly expenses is likely a struggle.
Now How Much Working Capital Do You NEED?
Now that you know how much working capital your business has, you can look at how much working capital your business needs. They tend to be two different answers.
If your company comes up short on working capital (as it did in our second example), this is a no-brainer. Your business obviously needs more working capital; you just need to know how much.
That’s where things get interesting. You may think that you need just enough to ensure that your assets cover your liabilities. But even businesses that already have positive working capital (as our first example illustrated) may need more.
If you want to ensure your company’s financial health and stability, you need secure at least enough working capital to cover a full operating cycle.
What is the Operating Cycle – and How Does It Affect Working Capital Needs?
When we calculated your current working capital, we looked at whether you have enough assets to cover your current month’s liabilities. Therefore, you might think that “enough” working capital means having enough to cover a month’s operating expenses.
This is a dangerous trap. The biggest mistake business owners make when calculating their operating expenses is ignoring (or not knowing) their operating cycle. An operating cycle is often more than one month long. You need enough working capital to cover a full operating cycle. The longer your operating cycle is, the greater the amount of operating expenses you will need to cover.
Financial professionals define an “operating cycle” as the period of time between when you start to spend money to create the goods and/or services you are selling and when you’re finally paid for delivering the goods and/or services. If it takes you 15 days to create and deliver your work product and 45 days to receive payment, your operating cycle is 60 days long. You need enough working capital to cover your liabilities and expenses for the entire 60 days. If your customers frequently take longer to pay or if you want to provide a cushion against any unexpected work delays, you might want enough working capital to cover additional days.
Imagine what would happen if you didn’t consider the operating cycle and used only your monthly expenses to calculate your working capital needs. You’d be constantly running short of cash.
How Much Working Capital Do You Need to Secure?
Now that you know how much working capital you need to cover your full operating cycle, you can figure out how much more working capital you need to secure. Here’s how you do it: Subtract the net working capital available (that’s the amount we calculated above) from the amount you need cover a full operating cycle.
Let’s go back to our examples from above. If the company that has $250,000 in working capital (a positive current balance) needs $600,000 to cover its full operating cycle, it comes up short by $350,000 ($600,000 minus $250,000). But if requires only $300,000 to cover an operating cycle, it needs to secure only $50,000 more in working capital ($300,000 minus $250,000).
If you still have a positive working capital balance after subtracting expenses for a full operating cycle, bravo! You officially have excess working capital. Many companies, however, will have a shortfall. This means they need to find ways to secure more working capital.
How to Calculate Your Operating Cycle Expenses
Obviously, it’s critical to know how much money you need to cover your operating cycle expenses. These expenditures include all operating expenses, such as rent, utilities, office supplies, fuels, insurance, and payroll. Operating expenditures also include the costs of delivering your products and/or services. These expenses would include inventory purchases, manufacturing and production costs, and service delivery costs.
If your operating expenses are fairly steady, you can use an average for calculating your operating expenses. But if yours is a seasonal business or your expenditures fluctuate a great deal depending on the month, consider using the operating expenses from your most expensive months when calculating how much working capital your business needs.
Another factor to consider is how much your business is growing. Business growth usually means growing expenses. If you’re in a high-growth business, think about multiplying your working capital needs by a growth factor.
Signs You Need More Working Capital
Obviously, using the calculations I’ve explained in this article will help you figure out how much working capital your business needs. But you may already be seeing the warning signs. Two common signs that you don’t have enough working capital are struggling to meet payroll and not being able to pay your bills on time. But even if you are current on expenses and liabilities, you may still need more working capital.
If you want help pinpointing the amount of working capital you should have available – or more