The amount of working capital a small business needs to operate smoothly depends on three different factors: the type of business, the operating cycle, and the business owner's future growth goals. While large companies can get by with negative working capital (because they can raise capital quickly), small businesses need to maintain positive working capital numbers.
Important points
- Working capital is the cash on hand used to maintain business operations, minus debts and obligations.
- Depending on the nature of the business, a large amount of working capital may be required to procure raw materials and labor.
- Service businesses, on the other hand, are much less dependent on working capital and can operate with lower overhead costs.
- Companies looking to grow and expand will require greater levels of working capital than companies looking to maintain their current size.
- A business's operating cycle also influences its working capital needs. Businesses that have a short time between production and revenue generation require less working capital.
What is working capital?
Working capital refers to the difference between a company's current assets and current liabilities. Current assets are items owned by a company that can be converted into cash within the next 12 months, while current liabilities are costs and expenses that a company incurs within the same period.
Common liquid assets include checking accounts, savings accounts, marketable securities (such as stocks and bonds), inventory, and accounts receivable. Current liabilities include the cost of materials and supplies (that must be purchased to produce goods for sale), short-term loan payments, and payments for rent, utilities, interest, and taxes.
Seasonal businesses require different working capital at different times of the year.
A company's working capital reflects operational efficiency and budgetary control. If a company has more current liabilities than assets, its working capital will be negative and it may have difficulty meeting its financial obligations.
On the contrary, a company with a very high working capital figure can easily pay all its expenses because it has enough cash left over. Whether a particular business requires significant amounts of working capital depends on three important factors: the type of business, its sales cycle, and its operating goals.
Type of business
Certain types of businesses require higher working capital than others. Businesses with physical inventory, such as retailers, wholesalers, and manufacturers, often require large amounts of working capital to operate smoothly.
Manufacturers must continually purchase raw materials to produce their own inventory, while retailers and wholesalers must purchase ready-made inventory to sell to distributors and consumers.
Additionally, many businesses are seasonal, requiring significantly higher amounts of working capital at certain times of the year. For example, in the lead-up to the winter holidays, retail businesses such as department stores and grocery stores need to increase inventory and staffing to accommodate the expected influx of customers.
Companies that provide intangible products or services, such as consultants or online software providers, typically require much lower working capital. As companies mature and are no longer capable of rapid growth, their need for working capital also decreases.
operation cycle
Ideally, a company can pay off short-term debt with sales proceeds. However, depending on the length of a company's sales cycle, this may not be possible. Companies that take longer to create and sell products require more working capital to ensure that they can meet their financial obligations during that time.
Similarly, businesses that bill customers for goods and services already provided, rather than requiring upfront payment, will require more working capital if accounts receivable are not collected quickly.
Management goals
A business owner's specific goals are another important factor in determining the amount of working capital a small business needs. If your small business is relatively new (and looking to expand), you will need a higher level of working capital compared to the working capital needed for a small business that intends to keep its business small.
This is especially true for companies planning to expand their product lines and enter new markets, as research and development, design, and market research costs can be significant.
How do you calculate working capital?
Working capital is calculated by subtracting current liabilities from current assets. Both current assets and current liabilities appear as line items on a company's balance sheet. Current assets include cash, securities, accounts receivable, and other current assets. Current liabilities are financial obligations that are due within one year, such as short-term loans, accounts payable, and corporate taxes.
What is working capital used for?
Working capital refers to a company's ability to finance business operations and pay short-term expenses. If a company has enough liquidity to pay its short-term debt, accounts payable, and other costs that are due within a year, it is performing well and has enough liquidity to cover its costs. We generate liquidity from our business operations. This indicates the company's financial health.
How can I improve my working capital?
Working capital can be improved by increasing assets and decreasing debt. Reducing a company's reliance on debt, negotiating better terms with suppliers regarding accounts payable, managing expenses more effectively, and reducing unrelated costs can all improve current liabilities. Collecting receivables faster, increasing the value of securities, and increasing inventory efficiency all help improve current assets.
conclusion
Working capital indicates how efficiently a business is operating. Having positive working capital (i.e., current assets exceed current liabilities) is important for small businesses because they don't have many other options to fall back on if their assets don't cover their expenses.
The amount of working capital available varies widely depending on the type of company. A company with a large inventory of physical goods requires more working capital than a company with a small inventory. Similarly, a company looking to grow will need more working capital than a company looking to maintain scale.
Finally, the operating cycle of your business will determine the level of working capital required. Companies that can produce and sell goods quickly require less working capital than companies that have a longer time between production and revenue generation.
