Calculate Your Working Capital the Right Way

Working Capital | LoanOne

Many small business owners have a difficult time understanding different financial concepts – not the least of which is working capital. What’s tricky is that it can have different meanings depending on the person you ask. You have read or heard that calculating your working capital only requires subtracting your current liabilities from your current assets.

However, more often that not, things prove more complex than that. You need to have a full understanding of working capital and the different factors that influence it if you want to get to the right number.

Experts suggest using the operating cycle as a tool for calculating your working capital. The operating cycle involves analysing the accounts receivable, accounts payable, and inventory in terms of days.

Simply put, the analysis of accounts receivable is done using the average number of days required to collect an account.

Inventory needs to be analysed by the average number of days needed to turn over product sales, from the moment your products come in your door to the moment they turn into cash. Accounts payable must be analysed based on the average number of days needed to pay your suppliers.

In most cases, businesses cannot use accounts payable alone to finance their operating cycle. This means that finance is required to boost your working capital requirements. Most businesses cover this gap by internally generated profits, externally borrowed money, or a combination of both.

You will find that at one point or another your business requires short-term working capital. A prime example is when retailers need working capital to purchase seasonal inventory between the months of September through November in preparation for the holiday sales.

However, even if your business isn’t engaged with seasonal products, you may notice that some months see higher sales than others, meaning you need to maintain your inventory. The build up in inventory and accounts receivable needs to be covered by coming up with enough working capital.

Some small business owners prepare for this event by increasing their cash reserves. For a new business, however, this can prove very challenging. If you have a small business that needs short-term working capital, you should know that you can get funding from several sources.

What’s important is that you know how to plan well ahead of time. Failing to do so means missing out on sales opportunities, especially huge orders that could provide your business with enough money to get over the hump.

Funding Sources

The following are five short-term working capital funding sources you should consider:

Equity

If you have a new business that hasn’t reached profitability yet, then you should look into equity funds for your short-term working capital needs. This proves the most accessible option for small businesses owners because it can come from your personal resources or those from family members, friends, or third-party investors.

Trade Creditors

Establishing a good working relationship with trade creditors should be a priority for all business owners as it comes in handy when trying to source funds for working capital requirements. If you have shown responsibility and punctuality in paying in the past, there’s a good chance that a trade creditor will accommodate extended terms so you can complete a big order. If the supplier provides 30-day terms, then you may ask to extend it to 60 days if you have a huge order coming up which you can fulfill within this period. Usually, the trade creditor asks for proof of the order and may even consider filing a lien, but this shouldn’t be a problem if it will enable you to proceed with the transaction.

Factoring

This is something not many small business owners know about. A factoring company can help with your working capital needs by buying your accounts receivable and handling the collection after you fill an order. Some business owners shy away from this method because it’s more expensive compared to traditional financing options from banks, but it can be just what you need to ensure there are no halts in your operations.

Line of Credit

Banks don’t normally give credit lines to new businesses. However, with enough capitalisation through equity or security in the form of a collateral, your business might just get approved for one. What’s great about a credit line is that it enables you to borrow money to cover your short-term needs anytime they arise. After collecting the accounts receivable, you must pay the funds. To make sure that the funds are only used for short-term needs, credit lines do not usually last longer than one year and need to be paid for 30 to 60 consecutive days.

Short-term Loans

If you haven’t had any luck with credit lines from the bank, try asking for a short-term loan to get enough funding for your working capital needs. This is where your relationship with a bank manager comes into play. The manager might agree to give you a one-time short-term loan to cover your seasonal inventory or accounts receivable buildup.

Other than calculating the average number of days required to make a product and collect an account vs the average number of days needed to finance your accounts payable, analysing the operating cycle provides another important analysis.

It’s high time that you have a thorough understanding of the impact of working capital on the cash flow of your business. You may not realise it right away, but it can spell the difference between a successful business and one that’s bound to fail before it even begins.