Working capital is one of the most difficult financial concepts to grasp for most small-business owners. The fact that it can be calculated in a few different ways only adds to the confusion.
By definition, working capital is the amount by which current assets exceed current liabilities -- and it can be calculated several ways:
However, if you simply run one of these calculations each month, you won't accomplish much in the way of highlighting what your working capital needs are or, more importantly, HOW to meet them.
Which Method is Most Helpful?
A more useful measurement tool for determining your working capital needs is something called the operating cycle (also known as your cash conversion cycle or cash gap). It's more practical in two ways - (1) once you know the number, it is easier to set targets to improve it and (2) you can use the number to help identify whether you have enough working capital to sustain your business next month, quarter etc. Your operating cycle measures your accounts receivable, inventory, work in progress and accounts payable cycles in terms of days. Here is the formula:
Here is a visual example:
Clear as mud, right?
Let's break it down a bit more so that you can get insights you can use to make it a little easier to operate comfortably (with enough working capital) next month.
What Does All Of This Mean in Plain Language?
When your accountant, coach or advisor wants to have a look at your operating or cash conversion cycle, essentially what they are doing is looking at:
This essentially tells you how long you are out of pocket (money has gone out of your business but none has come back in yet). Knowing this metric is crucial to putting a value on how much working capital you need to sustain you during the period while you are waiting to make and collect the sale. The longer the period is in days, the more working capital you will require.
And to calculate your operating (or cash conversion) cycle, you must first assess and calculate how many days (on average) it takes you to:
Financial Foreplay® : How To Apply This Knowledge To Your Business
Just for a moment, rather than focus on the math behind all of these calculations, I want to share with you the thought process behind why we are doing this and what it means to you and your business. Remember, you don't need to know how to manually calculate these metrics because you can use an app like Businest® to automatically calculate your operating cycle each month. So it is more important that you understand why this number is valuable and how you can use it to make good decisions about operating your business this month and in the future.
Now unfortunately, most businesses cannot finance their working capital requirements (goods, time and invoice collections) each month with accounts payable financing alone. The shortfall in cash for a number of days (your operating or cash conversion cycle), gives rise to the need for working capital financing and it is typically covered by the net profit of the business, borrowed funds, or by a combination of the two.
Almost every business needs short-term working capital at some point. However, most don't calculate or understand that they need it -- which means that they are continually on the back foot, reacting to the pressure of inadequate working capital. If you are able to measure and quantify your specific need for working capital, you will be at a distinct advantage this year -- (1) you can be proactive and address the need to find additional working capital and (2) you can set targets and communicate them to your team so that everyone is collectively working toward lowering the operating cycle (thus lowering the need for working capital).
If you are in retail, you will know how hard it is to fund the seasonal inventory build up between September and November in preparation for Christmas sales. The same is also true for businesses like pool cleaning, landscaping and lawn mowing who do the lion's share of their trade during the summer months. But even businesses that are not traditionally "seasonal" occasionally experience peak (or quiet) months. In addition to the normal operating cycle (the amount of time you are out of pocket waiting for sales to be collected), seasonality increases the need for working capital to fund the inventory (or work in progress) and accounts receivable build up.
Unfortunately, most small businesses are undercapitalized and simply don't have enough cash reserves to fund seasonal working capital needs. If your business currently is in need for short-term working capital, there are several potential sources you can look to for funding. The most important factor is of course to know you have a working capital problem (and also, you must be able to quantify it). If you don't, you could easily get caught off guard, and put the future of your business in jeopardy. Also, it is much more difficult to find viable solutions to a working capital problem if you don't have a clear handle on the magnitude of the problem.
Here are the five most common sources of short-term working capital financing:
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