Was that the word you shouted when you got your great idea for a business? Maybe not, but I’m pretty sure you didn’t shout WORKING CAPITAL!
When you envisioned your business you saw cool products, happy customers, and dollar signs dancing in your head.
You were and are passionate about your product, your customers and the success of your business – not how to calculate working capital.
The truth is that if you don’t regularly perform the working capital calculations of your business, it’s like driving a car without a fuel gauge. Running out of gas – or running a failing business – is not fun. Lack of resources to accomplish what you set out to do extinguishes your enthusiasm.
That’s why some number crunching is absolutely necessary to thrive.
You want to spend your time making your customers happy – that’s what you do best. Having healthy working capital numbers will give you the peace of mind to focus on what you love about your business.
Important Words to Know to Calculate Working Capital
- Current Assets are cash, cash equivalents, inventory, accounts receivable, prepaid expense, marketable securities, short term investments and any other asset that could be easily converted to cash in the next rolling 12-month period.
- Long-term Assets, which are not included in the working capital equation, are fixed assets like equipment, property, patents, or other long-term investments that will not be converted into cash in the next rolling 12-month period.
- Current Liabilities are accounts payable, short-term debt, short-term portion of long-term debt, accrued taxes, or any other obligation that must be paid in the next rolling 12-month period.
- Long-term Liabilities are obligations that are not due in the next rolling 12-month period. Examples are deferred taxes, deferred compensation, capital leases, pensions, and loans. Note that if you plan to sell a fixed asset and have a buyer ready to make payment, this amount could be moved to current assets.
- Liquidity measures how readily a business can honor their financial obligations using cash or cash equivalent assets.
Working Capital Defined
Now that your balance sheet memory has been refreshed, let’s talk about how to calculate working capital. Healthy working capital will allow you to grow your business by investing excess cash in generating more revenue.
Working capital also covers payroll, supplies, daily expenses, raw materials and anything else that the business requires on a daily basis to fulfill customer orders.
There are 3 important measurements related to the working capital of your business:
- Working Capital Cycle
- Net Working Capital
- Working Capital Ratio
All three of these numbers diagnose the liquidity of your business. Knowing where you stand among these measures helps you manage cash flow.
How to Calculate Working Capital Cycle
How quickly can you convert your current assets into cash? You can calculate the number of days in your working capital cycle by adding inventory days to receivable days and subtracting payable days.
Let’s say you own a specialty coffee roasting business. You buy raw coffee beans on credit from an importer. In 30 days, you will have to pay them (accounts payable days).
In 25 days after buying the raw coffee beans, you have roasted and sold them on credit to your coffee shop customers (inventory days). Your customers will pay you in 15 days (accounts receivable days).
INVENTORY DAYS + RECEIVABLE DAYS – PAYABLE DAYS = WORKING CAPITAL CYCLE
The calculation for the example above is 25 + 15 – 30 = 10. This means that you will be short on cash for 10 days.
On the other hand, you may run a cash (no credit) business so you get paid sooner than you have to pay. Think about the coffee shop owner that you sell roasted beans to. With cash only, they don’t have any accounts receivable.
They have 15 days to pay you for the roasted beans accounts payable) and they sell all their inventory in 10 days (inventory days).
The calculation for this cash (no credit) business is 10 + 0 – 15 = -5. This means your coffee shop customer has extra cash for 5 days. Different industries have different working capital cycles. Businesses that extend credit typically have at least a few days shortage of cash in every cycle.
This is a common problem for many businesses that can be solved by finding a source of working capital. You can increase your current assets, reduce your current liabilities, or get a working capital line of credit from a lender.
How to Calculate Your Net Working Capital
Lenders and investors will calculate net working capital to measure the health of your business. It is a simple equation.
CURRENT ASSETS – CURRENT LIABILITIES = NET WORKING CAPITAL
Building on the example of the coffee roasting business, let’s say you have:
Current Assets of $250,000
- Cash in the bank $50,000
- Accounts receivable $100,000
- Inventory $100,000
Current Liabilities of $200,000
- Accounts Payable $50,000
- Short-term Loan $100,000
- Accrued taxes $50,000
Our equation would be:
$250,000 – $200,000 = $50,000
This would leave you $50,000 in net working capital. You can invest this money in growth opportunities, i.e. hiring a salesperson, buying more roasting equipment.
Is there a specific dollar amount of net working capital that is evidence of financial health? No. Fifty thousand dollars might be a comfortable amount of excess cash for some businesses but not others.
How do you know if you have enough working capital? You will be able to answer that question using the working capital ratio.
How to Calculate Your Working Capital Ratio (a.k.a. Current Ratio)
A quick and easy measure of liquidity is the working capital ratio.
CURRENT ASSETS / CURRENT LIABILITIES = WORKING CAPITAL RATIO
Using the example above our equation would be:
$250,000 / $200,000 = 1.25
If the answer had been 1.00, you would know that your current assets equal your current liabilities. This tells us that current assets could pay off current liabilities. While it’s reassuring to know you could meet all your financial obligations, there is no excess cash to grow the business.
The actual answer of 1.25 puts you in a stronger position since your current assets could cover your current liabilities 1.25 times.
This ratio is helpful for lenders and investors as industries have benchmarks to show the relative strength of the business.
Is That Number Good or Bad?
It shouldn’t come as a shock that a positive number is better than a negative number when it comes to your net working capital and your working capital ratio. The exception to that is your working capital cycle days. We’ll get to that in a moment.
To understand how good or bad your numbers are, do some research and compare yourself to industry benchmarks for working capital. Is it common in your industry to have a working capital ratio of more or less than 1.00?
While positive net working capital and working capital ratio are good, you will want to strive for a low or negative number on your working capital cycle days. Remember our example above where your coffee roasting business had -5 days in your working capital cycle.
That benefits you by allowing your business to hold excess cash for 5 days. That cash could be earning interest in a bank account and creating more cash for you!
Your working capital numbers will fluctuate. Going back to our fuel gauge analogy, every time you drive your car, you burn fuel. In the context of your business, every day that you are open for business, you spend money.
Whatever your numbers are, know that you will make a good impression on lenders and investors if you know your working capital numbers. It means you’re paying attention – even if you aren’t where you want to be.
Do You Need to Improve Your Working Capital Position?
Imagine for a moment if there was a spectacular demand for your product. The market was hot and growing fast. A lot of competitors are trying to get into the market and dominate market share. You have more customers and orders than you thought possible.
Oh no! Even if you have customers beating a path to your doorstep, if you don’t have the cash to fulfill their orders, they will go to a competitor. That simple.
About 20 percent of small businesses fail in the first year and about half fail by the fifth year. About 25 percent make it to 15 years.
Of the businesses that fail, nearly 30 percent didn’t have enough cash to operate on a day-to-day business. About 42 percent of these businesses fail because the market doesn’t need their product.
Is there such a thing as having too much working capital? It depends. If you are hoarding cash and not investing in your business, lenders and investors might question your growth strategy.
How to Increase Working Capital
Speeding up cash flowing into the business and slowing down cash leaving the business is how to increase working capital. Let’s take a look at some practical steps you can take to increase your business’s working capital.
Streamline Your Accounts Receivable Collections
- Invoice immediately after delivery
- Invoice more frequently by breaking up balances due to installments
- Invoices should be itemized, totaled and include clear and simple payment instructions
- Make it easy for your customers to pay you by accepting multiple forms of payment
- Stay in touch with friendly payment reminders before the due date
- Lose your customers that habitually pay late
- Reward your customers for paying early
- Automate the accounts receivable process as much as possible
- Build and maintain a mutually beneficial relationship
- Go paperless
Streamline Your Accounts Payable and Negotiate with Your Suppliers
- Don’t be a chronic late payer! This is bad for your relationship and may include penalties
- Negotiate better pricing
- Work out better payment terms (i.e., 40 days instead of 30 days)
- Ask about discounts for early payments
- Automate the accounts payable process as much as possible
- Regularly check for overpayments, duplicate payments
- Prioritize and budget your payments
- Go paperless
- Reduce the amount of inventory you carry to reduce costs
- Avoid minimum order quotas so you can buy more frequently
- Unload obsolete by offering discounts or donate for a tax write-off
- Use forecasting to predict customer demand and to know the best time to reorder
Liquidate Unused Long-Term Assets
- Vehicles that aren’t being used
- Old equipment that has been replaced
- Unused land, buildings or furnishings
Of course, increasing profits by increasing revenue and reducing expenses is a no-brainer to maintain a respectable amount of net working capital. Unfortunately, businesses can streamline, negotiate and liquidate and still be constrained by limited working capital.
How to Find Working Capital
Not surprisingly, adjusting your working capital cycle and increasing profits is not always enough to achieve the growth you want for your business. Besides, many of the tactics listed above take time to deliver results and you may need liquidity immediately.
You are fortunate that there are so many options for small business owners today. The traditional borrowing process involves a lot of preparation, paperwork, and patience. If you need funds immediately, the traditional process won’t work for you.
If you are a busy small business owner wearing many hats – CEO, CMO, CFO – a lengthy application and approval process strains your already limited time. Sometimes the only minute you have to breath is on the weekend when traditional banks are closed!
In recent years, online lenders have filled a much-needed gap for small business owners. Online lenders have a streamlined process with reduced paperwork and shorter timelines to go from application to cash in the bank. Some of these companies have valuable online financial management tools available to clients.
How Do Working Capital Loans Work?
Lenders have different names for their loan products. The two key categories are term loans and lines of credit. Depending on the lender, you could use both a term loan or a line of credit to supplement your working capital. The type of loan you select depends on how you’re going to use it the funds.
For example, an accounts receivable line of credit allows you to borrow against your outstanding invoices.
The key factor to remember is that the concept of borrowing for working capital purposes tells the lender that the money you borrow is being used in the short term to increase revenues. In our coffee roaster example, you may want to hire a new sales employee to generate more coffee shop leads; or you may want to buy an additional piece of equipment to meet demand.
Experience the Difference of Readily Available Working Capital
Without a doubt, knowing how to calculate working capital is fundamental to wise financial management. As an ambitious entrepreneur, you know that the flow of cash in and out of your business will determine your success.