Working capital for small businesses is determined by the type of company, the operating cycle, and the owners’ plans for growth. While large companies can operate with negative working capital due to their ability to raise money quickly, smaller businesses need to maintain positive working capital.
Takeaways from the Key Notes
Working capital is cash to run a business minus liabilities and obligations.
Operating capital requirements can be high depending on the type of business. They may include raw materials, labor, and other costs.
On the other hand, service businesses rely less on working capital and can operate with lower overhead.
Working capital is required by companies that want to expand and grow, as compared to those that are looking to maintain size.
Working capital requirements are also affected by the business’s cycle of operations. Companies requiring less capital to generate revenue in a shorter period will need less.
What is Working Capital?
The difference between current liabilities and current assets is the working capital. Existing assets are items a company owns and can convert into cash next year. At the same time, current liabilities are costs and expenses incurred by the business during the same period.
Current assets include accounts payable, inventory, and marketable securities such as stocks and bonds. Current liabilities are the costs of purchasing materials and supplies to make goods that will be sold and payments for short-term loans, rent, utilities, and interest.
Working capital requirements for seasonal businesses vary throughout the year.
Working capital reflects a company’s operational efficiency and budgeting. If a company has more liabilities than assets, its working capital is negative. This means the business may be unable to meet its financial obligations.
Conversely, a company with high working capital can quickly pay for its expenses and still have plenty of funding. Three factors determine whether a business needs high working capital: the type of business, its operating cycle, and management goals.
Business Type
Some types of businesses require more working capital than others. Companies with physical inventory require a lot of operating money.
Retail and wholesale businesses, as well as manufacturers, can be included. The manufacturers must continuously buy raw materials to create inventory on-site, whereas retailers and wholesalers must purchase pre-made stock to sell to distributors or customers.
Many businesses also require much-working capital to ramp up during busy seasons. Retail companies, such as department and grocery stores, must increase their inventory and staffing in the weeks leading up to the holiday season.
Working capital requirements are generally lower for businesses that offer intangible services or products, like consultants or online software providers. Working capital is also less needed by mature companies not looking to increase.
Operating Cycle
In an ideal world, a company could pay off its short-term obligations with the revenue generated by sales. However, this may not be possible due to the length of their operating cycle. Companies that need a lot of time to develop and sell their product will require more working capital to meet the financial obligations they have incurred.
Companies that bill their customers for services or goods rendered rather than demanding payment in advance need higher working capital to cover the possibility that accounts receivable may not be collected promptly.
Management Goals
A small business’s working capital requirement is also affected by the goals of its owners. Operating capital requirements are higher for a new small business looking to expand than for a small company that wants to remain small.
It is especially true for companies that plan to expand their product line to enter new markets. The costs of design, market research, and research are often high.
How do you calculate working capital?
Calculate working capital by subtracting current liabilities from current assets. Current assets and liabilities are listed as line items on a balance sheet. Cash, marketable securities, and accounts receivable are examples of existing assets. Current liabilities include financial obligations due within a year, like short-term debts, accounts payable, and income taxes.
What is the purpose of working capital?
Working capital measures a company’s ability and willingness to pay for its short-term costs. If a company has enough cash to pay off its short-term debts, accounts payable and other expenses due within a year, it is operating well and generating enough liquid to cover the costs. This is a sign of its financial health.
How can I improve my working capital?
Increasing assets and decreasing liabilities can improve working capital. Current liabilities can be improved by reducing your company’s debt burden, negotiating favorable terms with suppliers for accounts payable, managing costs more efficiently, or cutting unnecessary expenses. Current assets can be improved by increasing the value and speed of your marketable securities, improving inventory efficiency, and collecting receivables more quickly.
The Bottom Line
A company’s working capital is a measure of how well it operates. A small business needs to have a positive operating capital. This means that current assets must exceed current liabilities.
Working capital varies greatly depending on what type of business you are. Working money is higher for companies with high inventories of physical goods than those without. Businesses that want to expand will also need more capital to operate than businesses that want to maintain their size.
The operating cycle of a company will determine how much capital is needed. Businesses that can produce and sell products quickly require less money than businesses with a long time between production and revenue.
