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:
- current assets – current liabilities
- current assets/current liabilities
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:
- debtor days + inventory days (or work in progress days) – days to pay creditors
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:
- the overall number of days it takes from when you use cash to purchase stock (or pay for labour and materials to create work in progress) to when you actually secure a sale and collect the cash
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:
- collect an account
- turn inventory or WIP into a sale and
- pay a supplier invoice.
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:
- Equity – If you are a start up or are not yet profitable, then equity funds may be your only alternative to cover short-term working capital needs. These funds could be injected by you, a family member or friend, an angel, or other investor.
- Creditors – If you have developed a strong relationship with your trade creditors, you may be able to negotiate better terms (on a one-off or ongoing basis) which will improve your working capital situation. If you have a history of paying on time, your creditors are much more likely to be willing to extend terms (especially if it means that you can place a big order for an upcoming busy period). Your creditors may ask to take a charge (or a lien) over the goods as security until you pay, but that is a small price to pay if it enables you to continue trading.
- Invoice Financing – What if you could use the funds tied up in your receivables to grow? There are many providers of modern invoice finance solutions that offer an option that resembles a perpetual line of credit (similar to how a credit card or bank overdraft works). Many of these will give you immediate access to the funds tied up in your receivables, so you can pay bills, fund growth strategy or used as a safety net during quiet trading periods. You can draw down and repay funds as you need, only paying interest on the balance. Often they will integrate seamlessly with cloud (online) accounting software such as Xero, MYOB and Quickbooks. Most are easy to setup, manage, and they can save you up to 15 hours per week over ‘old-school’ invoice financing.
- Line of credit – Lines of credit are extremely helpful but are often not extended to new businesses by most traditional banks. However, if you have strong trading history and sufficient collateral, you may be more likely to qualify for one. A line of credit is typically only extended when a business needs to borrow funds for short-term needs. The bank will often put terms or restrictions in place to ensure that the funds are used for short-term needs only.
- Short-term loan – If you are not able to qualify for a line of credit, you may still be able to obtain a short-term loan from a bank, non-bank or peer-to-peer lender. Depending on your situation they may or may not require that you put up security to reduce the risk.