Your business needs money – there’s no doubt about that. Cash allows you to purchase equipment and supplies, fund marketing campaigns and pay salaries – yours included!
But just how much working capital should you have at any given time? Every business has its own unique needs, so no two companies’ financial requirements will be the same. To determine what your business needs, take into account three factors:
- Your operating cycle.
- The type of business you run.
- Your business goals.
How operating cycle affects working capital
Your operating cycle can be determined by looking at your accounts receivable, accounts payable and inventory, and considering how long it’ll take to:
- How many days it takes to receive an account.
- How many days inventory takes to turn into cash or an account receivable.
- How many days it takes to pay an invoice.
In a perfect world, your operating cycle – that is, your accounts receivable days and inventory days – should run congruently with your accounts payable days. However, the typical business doesn’t run in a perfect world, Entrepreneur explained. Most business owners, therefore, need funds to cover expenses that are due before revenues are brought in.
Working capital needs depend on business structure
There’s a simple equation to determine how much working capital you have at a given time, My Accounting Course explained. Simply subtract current liabilities (costs and expenses that you’ll incur in the next 12 months) from your current assets (cash and things you own that can be converted to cash in the next 12 months).
Your current liabilities could consist of:
- Materials and supplies that will be used up in the next year.
- Payments that will be due in the next year, like rent, utilities debts and interest.
Your current assets might be made of:
- Stocks and bonds.
- Accounts receivable.
Depending on your business model, you might require a high amount of working capital because you require a large inventory. It’s also possible that you’ll need high inventory at certain times, but not so much at other points in the year. For example, a retailer should have a particularly high inventory during October and November to prepare for the holiday season.
On the other hand, some businesses can thrive with low working capital, such as, consultants don’t necessarily sell products so much as they sell their time and advice. Therefore, they have little need for inventory of any kind, so don’t require much working capital.
Business goals that impact working capital
Where do you see your business in the next year? How about the next five? Your business goals matter when determining your working capital needs. Some objectives you might have include:
- Growing your business.
- Expanding your reach.
- Increasing your product offerings.
All of these cost money (not to mention time and hard work). If you aspire to reach any of these goals, you’ll need to boost your working capital.
Additionally, if you’re just starting your business, you’ll require more working capital than you will in a few years, when you’re more established, or have reached a size that you’re comfortable with.
Many businesses find their working capital needs aren’t compatible with their operating cycles, business structures or ambitions. Entrepreneur pointed out that it’s common for business owners to take on short-term debt through resources like alternative lenders to bridge the gap.
Small and medium businesses are as unique as the people who run them. Your working capital needs won’t be exactly the same as another company’s. What’s important is that you determine what your needs are, and make the moves necessary to meet those needs.