Although it’s easy to understand what working capital is, it is more difficult to determine how much working capital your business actually requires. This is because your working capital needs will vary depending on several factors. These factors include:
- Your industry
- Operating cycle
- Overall efficiency
- Cash flow
- Inventory management
- Business goals
In addition to these components, your business has probably been affected by the COVID-19 pandemic this past year. Due to this, it’s likely that your working capital needs have changed, as you work to adapt to the ever-changing conditions.
By the end of this article, you will understand how each one of these factors affects your working capital performance, and how you can determine the working capital that your business needs to grow.
How Much Business Working Capital Do You Require?
1. COVID-19’s Affect On Your Business
Nearly every business, regardless of industry, has been affected in some way by the COVID-19 pandemic.
Due to this, having additional working capital is crucial during this time. As you adapt to COVID-19 conditions, you might need working capital for the following operational expenses:
- Payroll: If you’re struggling to pay your employees during this time, consider applying for additional working capital from a reputable lender.
- Safety investments: Most likely, your business will need to invest in protective equipment to keep your customers and employees safe. These might include shields, masks, new technologies, cleaning costs, or industry specific investments. If you need more financing to afford these costs, seeking additional capital will be helpful.
- Expansion opportunities: If your business wants to take advantage of new business opportunities during this time, calculate the working capital you’ll need to get started.
Every business is different, and the affect COVID-19 has had on your operations is no exception. During this time, reflect on the changes necessary to your business, the additional costs that may be incurred, and the new opportunities that may be available for growth. Each of these issues will have an effect on your required working capital.
2. Type of Business: Seasonality and Operating Cycle
The operating cycle of a company is defined as:
“The average period required for a business to make an initial outlay of cash to produce goods, sell the goods, and receive cash from customers in exchange for the goods.”
The type of business you run and your operating cycle go hand-in-hand. The key difference is that the time required for a business to receive cash from customers may vary quite a bit, even, between businesses in the same industry.
3. Seasonality of Sales
Your industry is also important because working capital needs may vary depending on seasonality. In some cases, you may need more cash on hand during busy seasons to meet all of your needs. Or, if sales slow down, you may require additional working capital to stay afloat.
For example, a retail store might not need a lot of money to pay for new inventory in Autumn or Winter, then, when the holiday season arrives, they’ll need to make large inventory purchases to capitalise on holiday sales. Recognising seasonality will allow you to determine the fluctuating amount of working capital your business entails and how that should be funded.
4. Operating Cycle
Your business’s day-to-day operations will majorly affect how much working capital you’ll need.
For instance, consider the differences in terms of working capital needs between a wholesaler and their client, a fast food restaurant.The fast food restaurant will order meat, potatoes, soft drinks, and any other ingredients they need to prepare menu items. Conceivably, the fast food restaurant owner could order a shipment, receive it a week later, and sell it the next day.
On the other hand, a wholesaler spends money on producing goods that may not be paid for until months later. Sometimes, they may only receive payment upon a customer’s receipt of the product. If that product must be shipped across the country, and the payment isn’t due until a month later, that business owner won’t have that cash for quite a while.
In this example, you can see why the wholesaler would need a larger amount of working capital during that time than the fast food business owner. The wholesaler simply can’t generate cash quickly enough to afford all his business expenses, so he’ll need a larger safety net. This example shows that your payment terms can greatly affect your working capital needs.
5. Your Business Goals
Your short term and long-term goals, particularly as they relate to investing in your business, play a large part in determining your business’s working capital needs.
For example, one business owner may be completely fine with having $100,000 in unused cash, while another might consider that amount to be too much. That’s because it depends on how much you want to invest in growing your business. In this case, it just comes down to whatever your personal preference is.
If your business is successful, and is growing its revenue, this can result in a strain on your cashflow. Knowing the effect that increased sales will have on your cashflow needs is imperative in order to plan for the funding that will be necessary to cope with that growth.
6. Operational Efficiency, Other Costs, and Payment Cycles
Small nuances in the way you do business make your needs unique. For example, you may have special taxes to pay or regulations to follow.
In addition, the timelines of when you receive payment for goods and services can affect your working capital needs. For these smaller reasons, you’ll have to be aware of all the small details of your business to be accurate when estimating working capital needs.
Conclusion: Know exactly what your Working Capital needs are
Evaluating and managing working capital needs will give you great insight into whether your business is operating efficiently. Plus, you will gain clarity on where you need to cut back, and where you can afford to spend surplus capital to enable you to grow your business.