Knowing Working Capital Requirements is Crucial for Growth
Many businesses fail because they lack sufficient working capital. Quite simply, companies that lack the means to fund their ongoing operations run out of cash. However, working capital is not only required for day-to-day operations. A business also needs funds to develop new products or services as well as to expand. Consequently, understanding how much working capital a company needs is crucial for survival and growth.
Calculating the working capital requirement (WCR) of a business will help determine how much capital will be required for continued growth. WCR is also a helpful metric for managing a business and determining ongoing funding requirements. The following explains how to calculate, interpret, and manage the working capital requirement of a company. First, here are some metrics and key performance indicators to help you understand how much working capital your business needs.
Working Capital
In accounting, working capital equals current assets minus current liabilities. Current assets include cash, inventory, accounts receivable (AR), and any other assets that can be turned into cash in one year or less. Current liabilities include accounts payable, short-term loans, and liabilities that fall due within one year or less.
Related: Why Your Business Has No Cash But Makes a Profit
Working Capital Ratio
The value of working capital represents the liquidity of a business and its ability to meet its immediate obligations. However, how much working capital a business requires, of course, depends on the size of the company. Consequently, a better guide to the liquidity of a business is the working capital ratio, Current Assets / Current Liabilities. This ratio indicates the company’s ability to meet its short-term financial obligations.
A working capital ratio of between 1.2 and 2.0 is considered healthy. Under one, you are in the realms of cash flow difficulties and possibly insolvency. However, an excessively high working capital ratio is not necessarily a good sign. If the ratio exceeds two, it could signify that the business is not fully utilizing its resources.
Working Capital Requirement
Working capital requirement indicates the amount of cash required to fund trading operations. Or, to put it another way, the funds needed to cover the timing difference between producing goods and receiving money from selling those goods. The formula for WCR is Inventory + Accounts Receivable – Accounts Payable.
If WCR exceeds working capital, the business will struggle to continue trading at the current levels. So, having working capital that at least equals WCR is crucial. However, working capital equaling WCR is best viewed as a minimum requirement because equilibrium would not leave any room for investing in growth.
Working Capital Cycle
The working capital cycle (WCC) is another metric to help you understand how much working capital your business needs. This number, Inventory Days + Receivable Days – Payable Days, represents the number of days it takes to turn net current assets into cash.
WCC is extremely useful for predicting and managing cash flow requirements. A positive WCC means that the business must wait for the cash from receivables before purchasing more products for resale. Alternatively, the company must have sufficient free working capital to fund the timing difference. A negative WCC means that the business collects the cash from the sales of products before paying vendor invoices for those products.
Related: What is the Working Capital Cycle and How Can it be Shortened?
KPIs to Manage Working Capital
Of course, if the business is persistently trading at a loss, running out of working capital is inevitable. However, profitable companies can also experience difficulties due to insufficient working capital, the reasons for which usually lie in the elements of the WCC calculation:
Inventory Days
Inventory days, Average Inventory / Cost of Goods Sold x Period Length, indicates the number of days it takes to turn over inventory. High inventory days mean that stock sits on shelves for a relatively long time. Low inventory days suggest that a business manages stock levels well and turns inventory into cash fast.
What constitutes healthy inventory days varies by industry. And there is a need to maintain sufficient stock levels to meet demand. As a general guide, though, turning over inventory every one to two months is generally considered a healthy position.
Receivable Days
Receivable days, or debtor days, indicate customers’ average time to pay their sales invoices. The metric for a year is calculated with the formula: Accounts Receivable Balance / Credit Sales x 365. Slow accounts receivable turnover is one of the most common causes of cash flow issues. However, it is also relatively easy to remedy by improving collection policies and procedures.
Payable Days
Payable days, Accounts Payable Balance / Cost of Goods Sold x Number of Days in Period, indicates how many days you take to pay vendors on average. High payable days could signify sound cash flow management and negotiating favorable terms with vendors. However, you would also have high payable days if the business struggled to pay creditors on time. Low payable days might indicate you are paying vendors too quickly.
Related: How Much Are Your Accounts Receivable Costing You?
The Bottom Line
There are many variables can affect the availability of working capital. The level of working capital requirement will also vary over time and be different for different types of businesses. Nevertheless, it is safe to say that every business needs
sufficient working capital to cover its working capital requirements. Plus, further funds will be required to fund expansion. If funds are insufficient to meet these needs, improving receivable, inventory, and payable days may be required. Alternatively, an injection of capital might be necessary.
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Universal Funding is a nationwide invoice factoring solutions leader, supporting growth-focused businesses with scalable factoringsolutions. With itsinvoice factoring, payroll funding, and purchase order financing services, Universal Funding provides clients with the working capital needed to grow and support their businesses without taking on new debt. Ranked as one of the nation’s top invoice factoring companies, Universal Funding provides cash flow financing for businesses all across the United States.
