Working capital is the lifeblood of every business. Yet, many business owners are not aware of how much working capital they use. In this article, we explain how to work it out.
Understanding Working Capital
Rod Fay is a Chartered Accountant and Director at Seacombe Services. He warns to make no mistake – understanding working capital is critical for your business’s ongoing success.
“Every business is going to get bumps and will be affected by various conditions,” he says.
“So how are you going to be able to cope with that if you don’t have a good understanding of your working capital and how cash flows through your business?”
The good news is that two simple formulas can help you determine this vital cash flow metric.
How to Calculate Working Capital
In a perfect world, you would sell stock or provide a service one day and get paid for it at the same time. Imagine if there were no lag between money out and money in. Consequently, there would be no need to hold funds within your business to make the next sale or cover expenses like wages, rent and tax.
Of course, in the real world, every business needs a pool of cash on hand to bridge the gap. This pool is the money available to fund day-to-day operations, known as working capital. These funds are the lifeblood of every business.
The concise definition of working capital, says Fay, is as follows:
Current Assets – Current Liabilities = Working Capital
To break that down:
- Current assets are things the business owns or has a claim on. These are items that a business can rapidly turn into cash. Think about your inventory and accounts receivable. Note that ‘current’ usually means within one year.
- Current liabilities are obligations that will soon fall due – think short-term debt and accounts payable.
If the answer to the above formula is positive, this means your business has more current assets than current liabilities. It also signals that your business has enough working capital to keep operating, even if conditions tighten up for a while.
Every business is different, but the more positive the sum, the better your working capital.
Rod Fay, Director at Seacombe Services.
Of course, the amount of working capital a business needs varies across the year. Therefore, drill down to quarterly or even monthly figures to see the true picture.
Working Capital Calculation Example
Imagine your business has $20,000 in cash and $50,000 in stock. Likewise, debtors owe you $50,000.
“These will generally be the three main components making up your business’s current assets, which in this case totals $120,000,” Fay says.
Next, you need to calculate the total owing to your creditors and short-term expenses. In this example, your accounts payable, payroll, taxes, monthly subscriptions and rent come to $100,000.
Fay says, in simple terms, you have $120,000 worth of assets that are realisable into cash. Likewise, you have $100,000 worth of liabilities. “You will, therefore, have a surplus of $20,000 in cash,” he explains.
“But that working capital formula by itself is not the be-all and end-all. It’s not the panacea for understanding your business.”
Let’s take a look at another formula that can help give you more insight into your business’s working capital now.
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Another way to get insight into working capital is to calculate how many days it takes, on average, for the money that goes out to come back in. This method is known as the ‘operating cycle’ or ‘cash-conversion cycle’.
To calculate your business’s cash-conversion cycle, you need three numbers:
- Inventory days: How long stock sits on your shelf, or how long your business has to pay for labour and materials to create a saleable product.
- Debtor days: How long it takes to collect payment from your customers.
- Creditor days: How long your business can hold on to cash before it must pay suppliers.
Here’s the formula:
(Inventory Days + Debtor Days) – Creditor Days = Cash-Conversion Cycle
Cash-Conversion Cycle Calculation Example
(55 inventory days + 45 debtor days) – 30 creditor days = 70 days
In this example, the business owner waits 70 days for their outlays to turn back into cash. But this is just a guide. The cycle can blow out if, for example, sales suddenly slow down. Alternatively, a smart business owner can also shorten the cycle by speeding up collections.
Fay adds that once you calculate your cash-conversion cycle, you can shorten the period you are out of pocket and plan your finance needs.
“Understanding how quickly you can get the conversion of your two major assets – your stock and debtors – is very, very important,” he says.
The typical cash-conversion cycle differs from one industry to another. Therefore, look for patterns and identify what the most successful businesses in each sector are doing right.
Zero in on Working Capital
By understanding your business’s working capital requirements, you can help shorten your cash-conversion cycle and plan for times of business stress. After crunching the numbers, you may still fear your business may be a little short on working capital. But, rest assured, there are finance options available.
Does the health of your business model need a quick freshen up? Download Prospa’s Profit and Loss Projection Tool to help you develop sales targets and pricing and adjust plans to improve profit projections.
Key Takeaways
As a business owner, it is vital to understand how much working capital you use and how cash flows through your business. There are two helpful ways to calculate your working capital. The first is through the following formula: Current Assets – Current Liabilities = Working Capital. Alternatively, you can calculate how many days it takes, on average, for the money that goes out of your business to come back in. This method is known as the ‘operating cycle’ or ‘cash-conversion cycle’.
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