Working Capital

What is working capital?

Working capital is the money needed to fund the normal, day to day operations of your business. It ensures you have enough cash to pay your debts and expenses as they fall due, particularly during your start-up period.

Very few new businesses are profitable as soon as they open their doors. It takes time to reach your breakeven point and start making a profit.

 

The working capital cycle

The working capital cycle measures the time between paying for goods supplied to you and the final receipt of cash to you from their sale. It is desirable to keep the cycle as short as possible as it increases the effectiveness of working capital.

The working capital cycle is made up of four core components:

  • Cash (funds available)
  • Creditors (accounts payable)
  • Inventory (stock on hand)
  • Debtors (accounts payable)

Diagram of the working capital cycle

 

The key to successful cash management is to be in control of each step in the cycle. If you can quickly convert your trading operations into available cash, you will be increasing the liquidity in your business and will be less reliant on cash from customers, extended terms from suppliers, overdrafts, and loans.

 

What's the right level of working capital?

The right level of working capital depends on the industry and the particular circumstances of the business.

For example: Businesses that only sell services, and do not need to pay cash for inventory need a lower level of working capital. Businesses that take a substantial amount of time to make of sell a product will need a higher level of working capital.

It is important you work out the right level of working capital you will need. If the working capital is too:

  • high -  your business has surplus funds which are not earning a return; and
  • low - may indicate that your business is facing financial difficulties.

The formula used to calculate working capital for your business is:
(NOTE: You will need figures from your most recent balance sheet)

working capital ($ value) =  current assets  -  current liabilities   

This calculation will not give you a sense of whether your working capital safety margin is wide enough. The working capital ratio (current ratio/liquidity ratio) will give you a better measure of liquidity.

 

Working capital as a percentage of sales

Most business owners have a clear idea of their weekly, monthly, or quarterly sales levels, so you may prefer to calculate how much working capital you need as a percentage of sales.

The formula used to calculate an estimate of working capital as a percentage of sales for your business is: (NOTE: You will need figures from your most recent balance sheet and profit and loss statement)

Working capital = (Inventory + accounts receivable - accounts payable)
as a % of sales                                 Sales x 100

and:

Working capital ($ value) = sales x (working capital as a % of sales)

For example: Working capital as a percentage of sales of 35% means that you need $35 for every $100 of sales to fund the sale to allow for the time delay in the working capital cycle.

This method is useful for businesses going through a period of growth and expansion to work out how much extra working capital you need if turnover increased by a certain amount.

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