How To Determine Working Capital Needs For Your Small Business

How To Determine Working Capital Needs For Your Small Business

It goes almost without saying that working capital is one of the most complex business concepts to understand. On the face of it though, it looks and sounds like any other business concept. It is easy to understand why and where the complexity comes from. For starters, the term ‘working capital’ means different things to different people. It simply lacks a universal definition. Either way, most business experts agree or will rather tell you that working capital is the amount by which your current assets exceed or surpass your current liabilities. Note though that if you run this calculation from time to time to analyze working capital, you won’t accomplish much as far as figuring out working capital needs and how to meet the needs is concerned. Read on to learn what it takes to determine working capital.

The Operating Cycle

The operating cycle simply analyzes the inventory. It also analyzes accounts payable and accounts receivable cycles in terms of days. In simple terms, the operating cycle takes into consideration the accounts receivable and analyzes the average number of days it will take to collect an account. Inventory on the other hand is analyzed by the average number of business days it takes to turn over the sale of a service or product. The days start counting from the point a product comes through your door to the point you convert the product to an account receivable or cash. Then there are accounts receivable, which are analyzed by the average number of business days it takes to clear a supplier’s invoice.

The Positive vs. Negative Working Capital Concept

Positive working capital is by all means a good sign of your businesses’ short term financial health. This simply means that your company has enough liquid assets remaining to cover expenses like short term bills. It also means you can internally finance business growth. Negative working capital is the exact opposite. It refers to assets that are not in effective use. This could be because a company is in dire need of liquidity or because of poor asset management. This also means a company will soon face financial difficulties once liabilities become due. Eventually, late payments to creditors and suppliers or more borrowing will become inevitable. This will result to low corporate credit for the company.

To avoid the above scenario, know where your assets are all the time. Manage them effectively. Get rid of the ones that have turn into liabilities because of maintenance costs. Then where possible, invest in new assets that can help you break even within a short time.

The Nature Of Business

The nature of the business you run plays a key role when it comes to determining your working capital needs. You may not need lots of capital if you are in a service oriented business. But just like your counterparts who deal with real products, you have to calculate the difference between your current needs and future needs.

Bridging The Gap

Many small businesses struggle to finance the operating cycle (inventory days + accounts receivable days) with accounts payable financing alone. That is where capital financing loans come into the picture. The loan simply comes in to cover the shortfall.

Note that new businesses always need startup funds, otherwise referred to as capital financing.  This is not entirely bad news as there are several ways through which a new business owner can source for funds. Equity, trade creditors, factoring and short term loans are all good examples of short term working capital financing.