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The amount of working capital a small business needs to run smoothly depends on three different factors: type of business, operating cycle, and the business owners’ goals for future growth. Large businesses can get by with negative working capital (because of their ability to raise funds quickly), but small businesses should maintain positive working capital figures.
Key Takeaways
- Working capital is the cash on hand used to keep a business operational, less liabilities and obligations.
- Depending on the line of business, working capital needs may be significant in order to procure raw materials and labor.
- Service businesses, on the other hand, rely far less on working capital and can operate with less overhead.
- Businesses looking to grow and expand will require larger levels of working capital than businesses looking to maintain their current size.
- A business’s operation cycle will also impact working capital needs; businesses with a shorter time frame from production to 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 the items a business owns that can be turned into cash within the next 12 months, while current liabilities are the costs and expenses the business incurs within the same period.
Common current assets include checking and savings accounts, marketable securities (such as stocks and bonds), inventory, and accounts receivable. Current liabilities include the cost of materials and supplies (that need to be purchased to produce goods for sale), payments on short-term debt, rent, utilities, interest, and tax payments.
Important
Seasonal businesses require different amounts of working capital at different times of the year.
A company’s working capital is a reflection of its operational efficiency and budget management. If a business has more current liabilities than assets, its working capital is negative, meaning it may have difficulty meeting its financial obligations.
A company with a very high working capital figure, conversely, is easily able to pay all its expenses with ample funding left over. Whether a given business requires high working capital is determined by three key factors: business type, operating cycle, and management goals.
Business Type
Certain types of businesses require higher working capital than others. Businesses that have physical inventory—such as retailers, wholesale businesses, and manufacturers—often need considerable amounts of working capital to run smoothly.
Manufacturers must continuously purchase raw materials to produce inventory in-house, while retailers and wholesalers must purchase pre-made inventory to sell to distributors or consumers.
In addition, many businesses are seasonal, meaning they require extremely high working capital during certain parts of the year. Leading up to the winter holidays, for example, retail businesses— such as department stores and grocery stores—must increase inventory and staffing to accommodate the expected influx of customers.
Businesses that provide intangible products or services, such as consultants or online software providers, generally require much lower working capital. Businesses that have matured and are no longer looking to grow rapidly also have a reduced need for working capital.
Operating Cycle
Ideally, a business can pay its short-term debts with revenue from sales; however, the length of a company’s operating cycle can make this impossible. Companies that take a long time to create and sell a product need more working capital to ensure that financial obligations incurred in the interim can be met.
Similarly, companies that bill customers for goods or services already rendered, rather than requiring payment upfront, need higher working capital if collection on accounts receivable cannot be made promptly.
Management Goals
The specific goals of the business owners are another important factor that determines the amount of working capital required by a small business. If the small business is relatively new (and looking to expand), a higher level of working capital is needed compared to the working capital needed by a small business intending to keep its operations small.
This is particularly true for businesses planning to expand product lines to venture into new markets because the costs of research and development, design, and market research can be considerable.
How Do You Calculate Working Capital?
Working capital is calculated by subtracting current liabilities from current assets. Both current assets and current liabilities can be found on a company’s balance sheet as line items. Current assets include cash, marketable securities, accounts receivable, and other liquid assets. Current liabilities are financial obligations due within one year, such as short-term debt, accounts payable, and income taxes.
What Is Working Capital Used for?
Working capital demonstrates a business’s ability to fund its operations and pay its short-term expenses. When a business has enough liquidity to pay its short-term debt, accounts payable, and any other costs due within one year, it is functioning well and generating enough liquidity from its business operations to cover its costs. This is a sign of the company’s financial health.
How Can I Improve Working Capital?
Working capital can be improved by increasing assets and decreasing liabilities. Reducing your company’s reliance on debt, negotiating better terms with suppliers on accounts payable, managing expenses more efficiently, and cutting extraneous costs can all improve current liabilities. Collecting receivables faster, increasing the value of marketable securities, and improving inventory efficiency can all help improve your current assets.
The Bottom Line
Working capital demonstrates how efficiently a business is operating. Having a positive working capital (i.e. current assets exceed current liabilities) is important for a small business because small businesses don’t have many other options to fall back on if its assets don’t cover its expenses.
The amount of available working capital differs greatly depending on the type of company. Companies with a high inventory of physical goods require more working capital than ones with a low inventory. Similarly, businesses looking to grow will need more working capital than those looking to maintain their size.
Lastly, a business’s operating cycle determines the level of working capital it needs: Businesses that can produce and sell goods quickly need less working capital than those with a longer duration between production and revenue generation.
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