A lack of cash flow, whether due to poor foresight and management or factors out of their control, accounts for up to 82% of failed companies in the UK. SMBs often find themselves caught short, waiting for customer payments at the same time as needing to pay suppliers. Growing and sustaining a business in these circ*mstances is challenging.
But there are solutions that can help reduce cash flow problems.
As an entrepreneur, you need to understand your working capital requirement (or WCR), how to calculate it, and why it’s so important. This article will help. You'll also find out what it means to have a positive or negative WCR.
Finally, learn how to optimise your company's WCR so that you can look forward to regular growth and sufficient financial resources.
1 - Working capital requirement: definition and interpretation
Before you can calculate your company's average WCR, or even optimise it, take a moment to find out what this financial term means.
1.1 - What is working capital requirement (WCR)?
Working capital requirement is the amount of capital required to run your business day to day at any one time. Before selling products and collecting payment from customers, your company must purchase goods, raw materials or services from suppliers.
Economic activity needs money to operate - you have to spend money to make money, as the saying goes. The working capital requirement therefore corresponds to this cash flow gap between outgoing operating flows (expenditure) and incoming flows (revenue). You need to cover it or finance it in one way or another.
1.2 - Positive and negative working capital
A business with positive working capital needs to find solutions immediately to cover this short-term cash requirement. This situation is typical of most businesses.
On the other hand, a business with a negative cash conversion cycle has surplus working capital. You're getting paid by customers before you have to pay suppliers for the raw materials required. So you can use this cash to make investments. This situation arises in particular when your customers pay cash (large-scale distribution or retail), so there is no delay in receiving revenue.
1.3 - Capital (C) vs working capital requirement (WCR)
In finance, there’s a slight distinction between capital and working capital. Capital is the amount of stable resources available, once durable fixed assets have been financed. In other words, the amount of money you need to create the company in the first place.
The key difference:
- Working capital requirement is the amount of funds or financing needed now to grow and finance ongoing costs.
- Capital is a more permanent measure of your assets versus liabilities. It includes equity and long-term debt financing, savings, and owned property.
1.4 - How growth and seasonality impact WCR
By definition, working capital requirements are linked to a company's operations. It is therefore more changeable than overall working capital. It can vary greatly depending on projects or the time of year, for example:
- Seasonal business will have a sales peak that requires stocks to be built up in advance (increasing the WCR);
- A growing business with increasing sales will need more inventory to keep up with demand. If there’s a real delay between sales and payments, the cash flow gap increases.
2 - What is the formula for calculating WCR?
When calculating working capital requirements, all the relevant items at the bottom of the balance sheet must be taken into account. Don’t under- or overestimate the level of cash required to operate your business.
2.1 - The general formula for calculating working capital requirement
The classic WCR calculation is as follows: WCR = current assets (-) current liabilities.
Let’s look closer at each component of this formula.
2.2 - Terms to be familiar with when calculating WCR
Current assets are short-term assets (excluding cash) that are used in the operating process:
- Inventories and work in progress
- Trade and other receivables (essentially outstanding customer invoices awaiting payment)
- Other operating receivables, such as deductible VAT or VAT credit to be refunded.
Current liabilities include short-term or operating debts (excluding cash):
- Accounts payable (mainly invoices received and awaiting payment)
- Social security liabilities (salaries and social security charges)
- Tax liabilities (including VAT collected and VAT payable, as well as corporation tax and local taxes).
3 - How are working capital requirements calculated?
There are two ways of determining working capital requirements. One is to calculate past working capital requirements from the accounts. The second is a standardised definition of WCR, which is useful for projecting the future, especially when business is fluctuating or growing.
3.1 - Calculating working capital from the balance sheet or trial balance
This is the classic method, using your latest balance sheet. Or, if your company has monthly statements, take the trial balance. Simply subtract the total current liabilities from the total current assets on these documents.
This is financial information based on actual data from the past.
3.2 - Calculation of normative working capital requirement
Another approach is more useful for cash flow forecasting. This is the case when the SMB is looking to expand, or is already experiencing a phase of steady sales growth. In these cases, it’s better to reduce the WCR to a number of days' sales. This is the concept of normative WCR, which involves breaking down the calculation for inventories, accounts receivable and operating liabilities.
In this way, the SMB is able to project the future level of WCR in euros/pounds/dollars as a function of its sales targets per season or per year. This is an excellent way of looking ahead before seeking financing, and a key to effective cash management.
3.3 - C-WCR = net cash flow
Another very practical and useful calculation is to check the following equation to analyse the financial structure of your balance sheet: C - WCR = net cash (NC).
You can also check your calculations with this second net cash formula:
- (+) Cash assets (cash in the bank, investments and in hand);
- (-) Passive cash (short-term financial debts, including bank overdraft, overdraft facility, cash loans and loan maturities of less than one year).
With this formula, you can see how all the items on your accounting balance sheet fit together:
- The top of the balance sheet is used to calculate working capital.
- The current items are used to calculate the working capital requirement.
- And the difference between the two (1-2) gives the company's actual cash position.
4 - Calculating working capital requirements in SMBs: when, why and what should you do next?
It’s vital to include working capital requirement among your key indicators to be monitored periodically. It’s a useful tool for anticipating and managing cash flow. WCR is a lever you can use to change your net cash position.
4.1 - Lack of cash remains one of the main reasons for business failure
Despite the existence of statutory payment deadlines, small and medium-sized businesses regularly encounter difficulties in managing their cash flow. This is especially true when dealing with large account customers. Conversely, the same categories of suppliers do not hesitate to demand short payment terms for their own invoices.
And maintaining inventory is a necessary evil if you want to develop your business. But you have to find the right balance between too little stock and too much. All these elements of current assets and current liabilities penalise professionals and can threaten the survival of structures.
4.2 - Good management and knowledge of WCR make it easier to manage cash flow
When you set up your business, your financing plan must include the initial working capital. If you omit this cash cushion, you risk penalising your start-up, and then lengthening the time it takes to achieve growth.
During the company’s lifespan, monitoring WCR is a way of assessing where you stand for each of the components in its calculation. It’s also a way of monitoring its evolution. By acting on one or more of the working capital items, the company can get some breathing space.
Are you entering a growth phase or a strong seasonal period? By controlling the forecast working capital requirement via the normative working capital requirement, you can look ahead. You can then look for the right financing to get through the cash flow peak or to grow your business.
4.3 - Organising working capital management in your company
It’s essential to monitor the WCR indicator, compare it with a target, and analyse its evolution over time..
These are the areas to study:
- Improve the coverage of WCR by increasing your capital base. This is ultimately the primary source of WCR funding, other than sales.
- Reduce WCR and therefore the level of cash required (see below for details of possible actions).
- Seek short-term WCR financing from a financial institution.
4.4 - Concrete examples of actions to optimise working capital requirements or finance them
Optimising working capital typically means reducing your requirements. Here are some ideas for your company:
- Review and enforce your payment terms and check that they make the most sense for your customers and industry.
- Speed up customer invoicing and improve administrative processes from order to payment, using the right tools and technologies.
- Deploy an effective customer reminder and collection process.
- Offer customer discounts for early payment.
- Develop advance payments for sales.
- Rationalise stock management, avoiding stockouts (shortages) and excessive stock rotation.
- Negotiate extended payment terms with suppliers.
- Look for short-term credit or an online factoring solution, as offered by Defacto.
Become a WCR expert for smooth, proactive cash management
Hopefully, you now understand your working capital requirement and how connected it is to your overall capital position and net cash flow. This is the key information you need to draw up business forecasts for your SMB.
And forecasts aren’t just for corporate finance experts. They’re a useful concept for the operational running of any business.
Defacto offers solutions to help you make the most of your receivables and debts. Use it as leverage to obtain the cash you need to grow and prosper.
Find out more about our platform and our range of financing solutions for working capital.
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