As a small business owner, you know the importance of generating cash flow and maintaining a strong liquidity position to prevent a cash crunch. But did you know that working capital might actually be your largest use of cash?
Small business owners often overlook their working capital needs which may lead to funding gaps or missed sales opportunities down the road. In this article, we’ll explain exactly what working capital is, how to calculate it, and how to manage it effectively for your small business.
What Is Working Capital?
Working capital is the difference between a company’s current assets, such as cash, accounts receivable, and inventory and current liabilities, such as accounts payable and short-term debts.
Working Capital = Current Assets – Current Liabilities
Often used as a measure of short-term liquidity, working capital represents the cash that is tied up by normal business operations.
Current assets are those that can be reasonably turned into cash within one year and include cash and cash equivalents, marketable securities, accounts receivable, and inventory.
Whether it’s having a physical cash register, extending credit to customers, or buying and holding inventory, you need cash to finance each asset and that’s why current assets are added to the working capital formula.
Current liabilities, on the other hand, are those that must be paid within one year and include accounts payable, wages payable, short-term debts, and the current portion of long-term debts like bank loans or mortgages.
In most situations, current liabilities actually improve your operating cash flow because third parties like suppliers, employees, and lenders are agreeing to provide you inventory, services, and loans on credit, rather than requiring cash upfront.
In other words, current liabilities represent a method of short-term financing and that’s why they are subtracted in the working capital formula.
How to Calculate Working Capital
Now that we’ve discussed the definition of working capital, let’s go over how to calculate it.
If your small business prepares regular financial statements, it’s as simple as checking the balance sheet and deducting current liabilities from current assets.
If you don’t have a recent balance sheet, however, you can still get a rough estimate of working capital using the following formula:
Working Capital = Cash & Cash Equivalents + Accounts Receivable + Inventory – Accounts Payable
This formula is very similar to the previous one but only includes the most common items from current assets and current liabilities.
Let’s run through a quick example:
Joe owns a shoe store and wants to project his working capital needs but doesn’t have a balance sheet statement.
Fortunately, he has collected the following information about his business:
Cash on Hand: $2,000
Cash in Term Deposits: $5,000
Accounts Receivable: $15,000
Inventory: $10,000
Accounts Payable: $3,000
Using the formula, we can calculate working capital as follows:
Working Capital = Cash on Hand ($2,000) + Cash in Term Deposits ($5,000) + Accounts Receivable ($15,000) + Inventory ($10,000) – Accounts Payable ($3,000) = $29,000
In this situation, Joe’s shoe store requires $29,000 of working capital to operate.
One thing to note, however, is that the cash in term deposits might not be required for day-to-day operations. If that’s the case, we can adjust the working capital required to $24,000, after removing the cash in term deposits.
Why Is Working Capital Important for Your Business?
Working capital isn’t just an obscure accounting metric – it has real-world implications for the health and growth prospects of your small business.
Here are four reasons why you should pay attention to working capital.
1. Working Capital Consumes Cash During Business Growth
Every business owner strives to grow sales year after year, but don’t forget to allocate enough cash for growing working capital needs as well.
Each incremental dollar of sales requires additional cash, inventory, and accounts receivable (however, this is partially offset by an increase in accounts payable).
The increase in working capital needed to fund operations ties up precious cash during periods of high growth which may lead to insufficient funds for reinvestment or missed business opportunities.
That’s why business owners need to understand their working capital needs and plan ahead to finance the growth in working capital accordingly.
2. Working Capital Can Dry Up During Business Downturns
On the other hand, managing your working capital is equally as important during economic downturns.
During recessionary periods, current assets like inventory become harder to liquidate and often require significant discounts to turn into cash.
Likewise, accounts receivable become harder to collect as customers may experience financial difficulties, with some potentially ending up in bankruptcy.
Meanwhile, current liabilities like accounts payable and short-term debts may suddenly become less flexible as suppliers cut credit terms and banks are less willing to extend short-term loans.
The net effect is the proverbial “cash crunch” as your business is simultaneously pulled by both sides of the balance sheet.
That’s why you need to understand the quality of your working capital as well, such as the ease with which you can convert assets into cash, as well as the reliability of your short-term financing sources like supplier credit and bank loans.
3. Excess Working Capital Reduces Business Profitability
Having too much working capital, however, is also detrimental as it reduces your company’s overall profitability.
That’s because every dollar of capital has a corresponding cost, so having idle working capital will decrease a business’s return on assets.
So, it’s important to determine how much working capital is required for normal operations, and return any excess capital to shareholders and owners, use it to pay down long-term debt, or invest in business opportunities, to name a few possibilities.
4. Reducing Working Capital Helps Free Up Cash
Finally, there are times when it’s appropriate or even necessary to trim working capital.
This might happen if sales are declining or the business just finished a seasonal build-up in inventory and accounts receivable (e.g. retailers during the holidays).
As working capital decreases, cash is actually returned to the business which can be used to fund operating expenses or pay down financial obligations.
It’s important to keep this benefit in mind as it can help your business survive temporary downturns and seasonal low periods.
How Much Working Capital Does Your Small Business Need?
When determining your working capital needs, consider the following factors:
Seasonality
If your business experiences seasonal swings in sales or only operates during certain times of the year, your working capital needs will fluctuate as well.
For example, a retailer needs to stock inventory ahead of its peak season.
RELATED: Does Your Small Business Need Extra Working Capital During the Holiday Season?
Industry Practices
Do your customers normally pay in cash or require months of credit? How about your suppliers?
Your working capital needs are largely determined by standard industry practices.
For example, businesses like restaurants receive a significant portion of their sales in cash, which reduces their working capital needs as they have less cash tied up in accounts receivable.
Compare this to industries like construction, finance, or government services, where most sales are made on credit, taking anywhere from a few days to a few months to receive full payment.
Inventory
Many small businesses these days are service-based and don’t carry traditional inventory, greatly reducing the amount of working capital required.
However, there’s likely still cash tied up in other short-term assets like supplies, prepaid utilities or taxes, and rent deposits, that should be factored into your working capital needs.
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Gravity Capital can help you grow your small business by providing extra funds when necessary.
We offer fast and convenient merchant cash advances that can be accessed within just one business day of accepting a funding offer.
Apply today to find out how much your business qualifies for, and learn more about our flexible repayment options.
