Working Capital: How to Calculate the Amount You Need
Working Capital (WC) is not only an indicator bankers use to quickly calculate liquidity – it’s also a vital financial resource to fund your company’s operations, especially during times of growth. Without sufficient Working Capital, businesses can fail – even with increased revenues and profit.
Working Capital is how cash is converted, or flows, to other current assets – Inventory and Accounts Receivable – so your business can develop products, sell them, and make a profit. While profit is the best source of cash, it takes not only good profitability but also good management of Working Capital, which involves converting non-cash assets back into cash, quickly and efficiently, to ensure sufficient cash for growth, or in some cases, to remain operational.
Knowing the amount of Working Capital required for growth is critical to success, so that you can borrow the correct amount for growth OR temper your growth to the limits of your WC, ensuring that you stay in business.
Calculating How Much WC You Need
- Review your latest Balance Sheet: Current Assets minus Current Liabilities.
- Calculate your current required Working Capital: Average Daily Sales X Cash Operating Cycle in Days.
- If your requirements are greater than your Current Working Capital, you will need to make decisions to ensure you have enough cash.
- For growing businesses, calculating the amount of WC required to fund the growth is the same calculation as above, but using your forecasted Balance Sheet and Income Statement instead of historic numbers.
Working Capital Strategies
In addition to actions that can be taken to manage Working Capital, strategies to improve Working Capital are important as well:
- Never use Working Capital to purchase long-term fixed assets. These should be purchased using term loans or leasing.
- Consider re-financing existing fixed assets (equipment, etc.).
- Obtain an equity injection from the business owner or sell stock.
- Required Working Capital should be evaluated regularly to determine if you have excess cash.
- If not invested, the excess cash is termed “lazy cash.”
- Examples of how lazy cash can be used are paying down debt or distributing to owners to invest personally.
For a visual walk-through of how to calculate the amount of Working Capital you need, watch my short video. Please contact me if you have questions about internal management of Working Capital or would like to discuss how I can help you optimize this vital financial resource or refine your processes.