How much working capital does your business need? Most business owners who want to determine their working capital needs ask themselves a simple question: “Do I or will I have enough money to pay my bills and payroll this month?” If the answer is yes, they think the business has enough working capital. If the answer is no, the owner starts to think about getting a loan or line or credit.
However, looking only at whether there is enough cash to pay the current month’s expenses does not accurately answer whether your business has enough working capital. To determine a company’s working capital needs, financial professionals use a different, more comprehensive process. Understanding this more technical definition of working capital and how it is calculated will help you determine your working capital needs. In addition, you will have a better idea of when the time is right to pursue a loan or line of credit.
The Technical Definition of Working Capital
Financial professionals define “working capital” as the “difference between your current assets and your current liabilities.” Current assets include cash, receivables, and inventory – anything that can be converted into cash to pay liabilities. Current liabilities include accounts payable and the current portion of loans payable (that is, the amount due in the current month), such as existing lines of credit, your office building mortgage, vehicle loans, and credit card payments.
For example, let’s look at a company that has $1.5 million in current assets and $1 million in current liabilities. To calculate working capital, we subtract current liabilities ($1 million) from current assets ($1.5 million), leaving $500,000 in working capital. In this example, the business has a positive amount of working capital.
However, not all businesses will be in this position. Consider a company that has only $450,000 in current assets, but $600,000 in current liabilities. The company is short $150,00 in working capital – and the business owner is likely scrambling to cover monthly expenses.
How to Determine How Much Working Capital Your Business Needs
How much working capital your business has can be very different than how much working capital your business needs. When a company is short on working capital, it is easy to determine that it needs more working capital. But even businesses that have several hundred thousand dollars of working capital, as in our first example, may need more.
For financial health and stability, a business needs enough working capital to cover a full operating cycle.
The Operating Cycle’s Role in Determining Working Capital Needs
The biggest mistake business owners make when calculating operating expenses as they relate to working capital is ignoring (or not knowing) their operating cycle.
When trying to determine their working capital needs, many business owners think in terms of covering a single month’s operating expenses. But your operating cycle is not necessarily only one month long. The longer your operating cycle is, the greater the amount of operating expenses you will need to cover with working capital.
The operating cycle begins when you start to spend money to create the goods and/or services you are selling. It ends when you are paid for delivering the goods and/or services you sold. For example, if it takes 30 days to create and deliver your work product and another 30 days to get paid, you have a 60-day operating cycle.
You need enough working capital to cover all necessary expenditures for the entire operating cycle – in this case, a full 60 days. If you have an operating cycle of more than 30 days and you were including only one month’s operating expenses when calculating your working capital needs, you would regularly fall short of cash. You may even want to have more working capital than is needed to cover a full operating cycle, in case a customer takes longer than 30 days to pay or it takes longer than average to deliver your work product.
Once you have calculated how much working capital is required for a full operating cycle, you can determine your working capital needs. Subtract the net working capital available from the amount required to cover a full operating cycle. The difference is your shortfall. If you have more working capital available than is necessary to cover a full operating cycle, then you have excess working capital.
As demonstrated by the examples above, your current working capital could be positive – or negative. If positive, subtract from working capital required. If negative, add to working capital required. Consider again the example company that has $500,000 in working capital. If it needs $400,000 to cover its operating cycle, it has $100,000 in excess working capital. But if it needs $700,000 to cover its full operating cycle, it needs an additional $250,000 in working capital.
What Expenditures Are Included in Determining the Funding Required for Your Operating Cycle?
Operating cycle expenditures include all operating expenses, as well as product/service delivery expenses you must pay. Depending on your business, your operating expenses may include rent, utilities, office supplies, gas for company vehicles, insurance, and payroll as well as the purchase of inventory, manufacturing/production costs, or service delivery costs, etc.
You may use a monthly average in stable/low-growth situations. However, if your expenditures vary widely depending on the month (for example, in a seasonal business), you may want to use the operating expenses from your highest-outlay months when determining your working capital needs.
In a high-growth business, you may want to multiply your working capital needs by a growth factor.
Do You Need More Working Capital?
Having difficulty meeting payroll and not being able to pay your bills according to terms are two common signs that your business may not have enough working capital. On the other hand, you may have enough working capital to avoid dire problems like these, yet still not have the amount of working capital you need for your business to run smoothly and grow steadily.
Use the information shared in this article to determine a rough approximation of how much working capital you need. If you recognize that you need more working capital or if you’d like help to determine your working capital needs, please contact Mac or Savoy Bank. Our Lending Team is here to help.
Mac Wilcox is the President and Chief Executive Officer of Savoy Bank. With more than 20 years of experience as a banking leader and entrepreneur, Mac is a strong believer in small businesses and the power of local entrepreneurs to drive economic development and growth.