A business's working capital is used to run its day-to-day operations. It is calculated as the company's current assets minus its current liabilities. Working capital can also be a measure of a business's efficiency with using cash and its short-term financial health.
While startups usually need some form of working capital at the beginning, growing companies also require an increasing amount of it to keep up with sales and expense investments.
Companies generally need to know their exact working capital inside their business, what affects it and how to grow it when needed. The following tips can help:
1. Determine what the working capital number is.
First, calculate what the current ratio for the company is. This is defined as current assets divided by current liabilities. Current assets are cash, inventory, accounts receivable and any other assets that could be turned into cash in less than a year. Current liabilities include accounts payable that must be paid in cash within a year like vendor payments, taxes and any payments for long-term debts.
If the current ratio is greater than one, it can mean there is enough short-term assets to pay any short-term business liabilities. A current ratio of two or higher, indicating current assets are at least twice as much as current liabilities, is a target for many businesses, but this will vary by industry.
If the current ratio is less than one, it can mean that any current liabilities business owners are paying are costing the company more money than the assets they are bringing in. Typically, companies with a working capital ratio of less than one may have trouble paying their bills. This financial position is typically not sustainable and must be improved if the company is to continue to function.
2. Determine how the company's operating cycle affects working capital.
The company's operating cycle can be determined by reviewing accounts receivable, accounts payable and inventory. In these areas, find out on average how many days it takes to collect a receivable from a customer, how long does a product sit in inventory before it is sold and how many days it takes for the company to pay a vendor.
Optimally, the accounts receivable days plus the inventory days should be less than the accounts payable days—this can provide positive cash flow for the company. However, most small-business owners need additional working capital funds to cover expenses that are due before cash sales are collected from customers.
How fast the company grows can also affect this equation. Most companies need to invest in expenses ahead of receiving cash from customers for sales. This can increase the working capital needs beyond what the company generates and requires for its current operating cycle.
3. Calculate how much working capital is actually needed for the company.
This can depend on the current ratio and the forecasted growth rate.
For example, let's say the company has $100,000 of current assets, $50,000 of current liabilities and the current ratio is two. If the company wants to grow 25 percent in the next year, then working capital will need to be increased from $50,000 to $62,500. Working capital calculators can help determine what is exactly needed.
How to Grow Working Capital
If a business doesn't have enough working capital to operate or grow their company, there are a few methods that can help address that issue.
1. Reduce overall expenses. If sales remain the same, this can help increase the business's profit and cash flow over time.
2. Shift to long-term liabilities. Moving any debts to be paid off over a longer period of time can help increase working capital. This can be done when credit cards or bank line of credits are converted to longer term loans.
3. Delay paying bills. Getting longer terms to pay vendors can help keep more cash in the business. It can also help improve the company's operating cycle, making it require less additional working capital.
4. Accelerate accounts receivable collections. This can help improve the operating cycle and bring cash into the business sooner as well.
5. Turn inventory over faster. The more time inventory sits unsold, the more cash investment is needed to keep it there. Pushing inventory faster can help the operating cycle and reduce working capital.
6. Get a bank line of credit or other capital infusion. This may give the company more cash on hand to meet the needs of the operating cycle.
Read more articles on managing money.
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