How exactly to Determine Your Working Capital Needs

Working capital is probably the most challenging financial concepts for the small-business owner to comprehend. In fact, the word means a whole lot of different things to numerous differing people. By definition, working capital may be the amount where current assets exceed current liabilities. However, in the event that you simply run this calculation each period to attempt to analyze working capital, you will not accomplish much in determining what your working capital needs are and how exactly to meet them.

A far more useful tool for determining your working capital needs may be the operating cycle. The operating cycle analyzes the accounts receivable, inventory and accounts payable cycles with regard to days. Basically, accounts receivable are analyzed by the common number of days it requires to collect a merchant account. Inventory is analyzed by the common number of days it requires to carefully turn over the sale of something (from the idea it will come in your door to the idea it is changed into cash or a merchant account receivable). Accounts payable are analyzed by the common number of days it requires to pay a supplier invoice.

Most businesses cannot finance the operating cycle (accounts receivable days + inventory days) with accounts payable financing alone. Consequently, working capital financing is necessary. This shortfall is normally covered by the web profits generated internally or by externally borrowed funds or by a combined mix of the two.

Most businesses need short-term working capital at some time in their operations. For example, retailers must find working capital to invest in seasonal inventory buildup between September and November for Christmas sales. But a good business that’s not seasonal occasionally experiences peak months when orders are unusually high. This creates a dependence on working capital to invest in the resulting inventory and accounts receivable buildup.

Some smaller businesses have sufficient cash reserves to invest in seasonal working capital needs. However, this is rare for a fresh business. If your brand-new venture experiences a dependence on short-term working capital during its first couple of years of operation, you should have several potential resources of funding. The main thing is to plan ahead. In the event that you get caught off guard, you may miss out on the main one big order that could put your business over the hump.

Listed below are the five most common resources of short-term working capital financing:

  1. Equity . If your business is in its first year of operation and hasn’t yet become profitable, you then might have to depend on equity funds for short-term working capital needs. These funds may be injected from your personal resources or from a member of family, a pal or a third-party investor.
  2. Trade creditors . For those who have an especially good relationship established together with your trade creditors, you may be in a position to solicit their assist in providing short-term working capital. For those who have paid on time previously, a trade creditor could be ready to extend terms to help you meet a big order. For example, if you get a big order you can fulfill, ship out and collect in 60 days, you could obtain 60-day terms from your own supplier if 30-day terms are usually given. The trade creditor will need proof the order and could want to file a lien onto it as security, but if it allows you to proceed, which should not be considered a problem.
  3. Factoring . Factoring is another resource for short-term working capital financing. After you have filled an order, a factoring company buys your account receivable and handles the collection. This kind of financing is more costly than conventional bank financing but is often utilized by new businesses.
  4. Credit line . Credit lines are not often distributed by banks to new businesses. However, if your brand-new business is well-capitalized by equity and you have good collateral, your business might be eligible for one. A credit line allows you to borrow money for short-term needs if they arise. The funds are repaid once you collect the accounts receivable that resulted from the short-term sales peak. Credit lines typically are made for just one year at the same time and are likely to be paid for 30 to 60 consecutive days sometime through the year to make certain the funds are used for short-term needs only.
  5. Short-term loan . While your brand-new business may not be eligible for a credit line from a bank, you may have success in finding a one-time short-term loan (significantly less than a year) to finance your temporary working capital needs. Assuming you have established an excellent banking relationship with a banker, they might be ready to give a short-term note for just one order or for a seasonal inventory and/or accounts receivable buildup.

Furthermore to analyzing the common number of days it requires to generate a product (inventory days) and collect on a merchant account (accounts receivable days) vs. the quantity of days financed by accounts payable, the operating cycle analysis provides an added important analysis.

You can view that working capital includes a direct impact on cashflow in a business. Since cashflow may be the name of the overall game for all companies, a good knowledge of working capital is vital to making any venture successful.