Unfortunately, there isn’t an easy one-size-fits-all answer. Working capital needs differ from business to business and industry to industry and ultimately depend on how your company operates and what its goals are. We’ll break down the info you need to know.
Before You Dive In
- Working capital measures your company’s liquidity to cover operations
- You can calculate it using Current Assets – Current Liabilities
- How much working capital your company needs will depend on many factors about your business
How Much Working Capital Does a Small Business Need?
Working capital is an essential topic for small business owners to understand, so we’ll break it down.
What Is Working Capital?
Working capital is a measure of your company’s liquidity to handle day-to-day operations. You can calculate working capital using the formula:
Current Assets – Current Liabilities = Working Capital
That means that things like inventory and cash add to working capital while other assets, like machinery and land do not. What you’re really trying to figure out is how much cash your company could come up with on relatively short notice.
Why Is Working Capital So Important?
Working capital is important because it measures your company’s liquidity. Without cash or things that can be turned into cash quickly, your business can’t pay its bills, even if it owns millions of dollars worth of less liquid assets.
Your company needs some amount of liquid cash to be able to run its daily operations so having adequate working capital is essential to keep your business running. Without working capital, your company’s operations could grind to a halt as you fail to pay your bills and struggle to do things like replace inventory.
How to Calculate Your Company’s Working Capital Needs
Working capital is all about your company’s ability to operate and pay essential bills. It’s important to know how much working capital you need to be comfortable.
A popular working capital ratio for most companies is between 1.2 and 2. Ratios under 1 are a warning sign that you could struggle to pay. Higher ratios give you more flexibility at the cost of not reinvesting those funds into growth.
To figure out how much working capital you need, start by determining your business’s typical current liabilities. You can use this formula:
Accounts payable + short-term loans + accrued expenses + unearned revenue + current portion of long-term debts + other short-term debts + notes payable = Current Liabilities
You’ll likely want to find your average current liability over a period such as a month or a year.
You can then multiply that by your desired working capital ratio to find your required current assets to generate the desired working capital.
Example of Working Capital Needs Calculation
Imagine you want to have a working capital ratio of 1.5 and that your company has an average of $125,000 in current liabilities over the course of a year.
To find the required current assets to generate that working capital ratio, multiply $125,000 by 1.5.
$125,000 * 1.5 = $187,500
That means that your required working capital is:
$187,500 - $125,000 = $62,500.
If you keep your working capital around $62,500, you’ll have a working capital ratio of about 1.5 which should be comfortable for your company.
Factors That Affect How Much Working Capital a Business Should Have
While working capital ratios between about 1.2 and 2 are common, how much working capital you really need will depend on many factors about your business. Here are some of those factors.
The type of company that you run plays a big role in how much working capital you provide. For example, inventory-heavy businesses, especially those with expensive goods for sale, will want more working capital available. That extra working capital will be important to replenish sold inventory.
Service-based companies can operate well with less working capital.
The length of your company’s operating cycle also determines working capital needs. The operating cycle is how long it takes for your company to buy inventory, receive it, sell it, and get paid. Shorter operating cycles mean it takes less time to turn inventory into cash.
The longer your operating cycle, the more working capital you’ll need to handle the length of time it takes to get paid.
As your company’s sales increase or you begin to offer new products, its working capital needs will also rise. If management is focusing on growth and expansion, having more working capital will offer more flexibility.
Many companies are seasonal and see significant peaks and troughs in sales. For example, vacation-based businesses or landscapers might see big seasonal swings in sales.
If you run a seasonal company, your working capital needs will change with the seasons. You might need more cash during busy times to be able to make quick purchases of more materials or inventory and less during quiet times.
If you’re in a fiercely competitive industry, having more working capital available gives you the opportunity to respond to changing conditions or jump on business opportunities. Less competitive businesses don’t need that level of flexibility.
Vendor Credit Availability
Working capital is all about being able to keep your business running and having the ability to pay the bills. If you have the option to purchase inventory or supplies from vendors with generous credit terms, that reduces the immediate need for cash to pay the bills.
The more credit you receive from vendors, and the more time they give you to pay the bills, the less working capital you need.
The more efficient your company is, the less working capital it will need. Efficient companies are better at generating cash when needed.
Your inventory turnover is a major factor in determining working capital needs. The faster you can sell products and get paid, the less cash you need to keep on hand to deal with the bills. Businesses with slower turnover will want to have more working capital available.
Scale of Operation
Your company’s working capital needs scale directly with the size of your operation. A company with small liabilities and bills to pay only needs a bit of working capital. A multi-million-dollar operation will need tens of thousands of dollars in working capital available.
What to Do If Your Company Needs Additional Working Capital
If you find yourself in a situation where your company needs more working capital, there are a few things you can try.
One is to try to reduce your business’s expenses. The less you spend, the less working capital you need.
You can also try to improve your processes. If you can boost inventory turnover or collect your accounts receivable in less time, that can mean less strain on your finances and more comfort at lower levels of working capital.
Increasing revenue is another way to boost your company’s working capital by helping it earn more money.
While borrowing money isn’t good for working capital because it increases your liabilities, having access to a line of credit may also be helpful for business owners. If you’re in a business where you sometimes need quick access to cash, having that line of credit available can help you when working capital runs low and you’re waiting on payment from customers. You might like to review funding opportunities we recommend on our list of the best working capital loans to learn more.
Working Capital Mistakes to Avoid
Many business owners make mistakes when thinking about working capital. These are some common mistakes to avoid.
- Ignoring seasonality. Seasonal companies need more working capital during busy times than slow times, so it can be easy to run low when you need more capital available.
- Forgetting changes in operations. Working capital needs change as your company does. For example, if you change invoicing processes and suddenly get paid more slowly, you’ll need more working capital.
- Letting customers and suppliers determine payment terms. When you run a business, you want to have as long as possible to pay your bills and give your customers as little time to pay you as possible. Negotiate with your customers and suppliers to come up with payment terms that help your business.