Calculating working capital for your small business
What is working capital? In a nutshell, working capital is the amount of money your business needs to meet its everyday financial obligations and still operate successfully. It’s the amount you need in available cash so that you can pay suppliers and employees, take care of maintenance costs, buy in stock, and pay your overheads.
How do you calculate what your working capital is?
The calculation for working capital is straightforward. Working capital is current assets minus current liabilities. Anything in your business that can be converted into cash within a year is a current asset. Anything that’s due within a year is a current liability. You’ll find these in your balance sheet.
Current liabilities include any bills that you haven’t paid yet, and current assets include things like your current inventory of stock, your account receivables (debtors) and cash-at-bank.
What makes working capital so important?
According to the government, just over 10% of companies fail in their first few years of trading. Not because they’ve underestimated the need for a product or service, but because they haven’t allowed for variations in their working capital. As a small business owner, this is why it’s important for you to think about how you’re financing your day-to-day operations and to keep a tight rein on understanding how much working capital you have to hand.
The right amount of working capital will help you to grow. Not enough working capital will impinge on the period of time you can handle between paying your suppliers and getting money from your customers. This is called the working capital cycle (WCC).
Obviously, the right levels of working capital help you to run your business with peace of mind, by keeping your bank account in the black.
Working capital may be increased by:
- Your business working well
- Selling long-term assets held by your business
- Borrowing, long-term
- Making a personal investment into the business
Working capital can decrease from:
- Business operations that are unprofitable
- Buying long-term assets with long-term financing
- Settling long-term debts
- Taking cash out of the business
To investors, well-managed levels of working capital can be a good measure of a small business’s potential and success. That said, any signs of strain on working capital are a warning that – if market conditions weren’t to be favourable and sales went down – a business might not be able to meet its financial liabilities.
A shortage of working capital can lead to problems, day-to-day. What’s more, any extra pressure on working capital may be a sign that something needs addressing in your overheads. It may be time to reconsider your business’s financial model.
What affects your working capital, day to day?
Every business operates a different way. Those characteristics make you unaverage, and give you a competitive advantage. But there are some commonalities in the way that working capital is affected by your operation. In the main, there are three things that have an impact on the amount of working capital your business has to hand. Your receivables (or debtors), your stock, and your liabilities (sometimes known as payables or creditors).
Debtors have a direct and instant impact on your working capital calculations. This is why getting support to help you to stay on top of debtors, is so important. Any business that’s not collecting amounts payable promptly is running the risk of not having enough working capital to operate responsibly.
At the same time, your stock needs to be kept at the right level. If you don’t have enough stock in-house, or within your supply-chain, then the result could be a loss of business. But if you have too much stock to hand, or you’re holding stock that’s out of date, then you’re impacting negatively on your working capital. This can leave you unnecessarily exposed.
Strangely, creditors (amounts payable to other people) often have the most tangible influence on your finances. The longer you take to pay your debts, the longer you retain cash-at-bank – working capital – that you can use in your operations. However, there’s a fine balance to be maintained here between lean accounting practice and robust reputation management.
When do you first need working capital?
Most small businesses can’t start trading without some working capital. That may be in the form of personal investment, and it may only be a small amount, but you’ll need to set-up a limited company, cover the value of your inventory, or pay for development of your product or service – and keep the lights on. Until you get paid by customers, you’ll need a certain level of working capital.
When should you plan to get more working capital?
Many small businesses can’t predict how much money their company will bring in during the first couple of years. Even with an in-depth understanding of traditional sales cycles, the working capital question may go unanswered for quite some time. But if your business is already growing, or you’re thinking about expansion in the long term, then it’s never too soon to review your working capital.
You might need to increase your credit levels with suppliers, buy more stock, employ more people, finance market research,or even cover expenses. Or, in the shorter term, your business’s needs may be driven by seasonal change.
In a retail business, for example, you may see peaks and troughs during the summer holiday season or in the winter. If sales are up, you may be incurring higher overheads at the same time. If sales are down, your inventory may need adjusting. In either case, a different level of working capital may be needed to help you operate, day-to-day.
How much working capital do you need?
To answer this question, you have to review your operating and selling cycles. You need to understand when sales will happen, what your day-to-day costs are, and what the gap will be between invoices going out and bills coming in.
If your calculations are based on previous sale history, this may be a relatively easy exercise. But in many small businesses (particularly those in a growth or start-up phase), there can be a lot of guesswork involved the first time around.
This is where it’s so useful to have the support of financing experts. The right team can help you analyse the number of days it will take for current assets to be transformed into cash, and the number of days until that cash needs to settle outstanding liabilities.
As a business owner, you can also compare your business to other similar businesses. If possible, create regular ‘management accounts’. Use your balance sheet to monitor the amount of working capital your business has on a monthly or weekly basis (current assets minus current liabilities). It’s also very important to create a cash flow forecast.
It is incredibly important to understand how the working capital cycle works in your business and to seek guidance if the financial trends indicate working capital is coming under pressure.
Please note that these guides are provided for information purposes only and not as advice or recommendations. Before deciding to undertake any course of action you may wish to seek independent professional advice.