Understanding your business' working capital needs is the key to unlocking business growth. But knowing how much working capital your business needs and how to continuously manage it, can be a bit tricky. Working capital can mean a lot of different things to a lot of different business owners. So, we’ve put together a quick rundown to give you a better understanding of exactly what working capital is and how to get it working for you.
Most business owners will be familiar with working capital; it refers to the difference between a business’ current assets and its current liabilities. In this sense, current assets are basically anything that a business owner can turn into cash within the next 12 months, while liabilities are the costs and expenses a business incurs within that same period.
A business’ working capital is basically a reflection of its current short-term financial health and indicates whether a business has enough short-term assets to cover daily operations and short-term debt. However, while they are similar, working capital and cash flow are not the same. Both are critical measurements of a business’ financial health but working capital is a snapshot of a present situation, while cash flow measures a business’ ability to generate cash over a specific period of time. Most businesses with high cash flow will also have high working capital, however, there can be some divergence depending on things like investments, paying off old debt and paying dividends to shareholders.
Assessing Your Working Capital Needs
Generally, a business will want a positive working capital ratio (Current Assets/Current Liabilities). While theoretically, a business with a working capital ratio of 1.0 should be able to adequately meet all of its short-term expenses, most businesses (and analysts, banks, accountants etc.) will like to see that number slightly higher. Excess working capital will give a business a kind of ‘cash cushion’ against any unexpected expenses and can be reinvested back into the business to help fuel growth. However, a ratio below 1.0 indicates a business’ current assets aren’t enough to cover short-term debt and could potentially mean a business needs additional external funds.
A ‘healthy’ working capital ratio is generally considered to be somewhere between 1.2 and 2.0 and indicates a good amount of liquidity and good overall financial health. However, a working capital ratio that’s too high could also be a problem. While not exactly a ‘bad’ problem to have, a ratio higher than 2.0 could mean a business isn’t making the most of its excess cash and assets by actively investing them into expanding the business. This may indicate poor financial management and missed business opportunities.
How to Manage Your Working Capital
The amount of working capital a business needs to run smoothly will vary depending on a range of factors, including business type, operating cycle as well as current and future growth aspirations. While large businesses can get away with a negative working capital ratio for a short-term (because of their ability to raise funds quickly), small to medium businesses need to actively maintain a healthy level of working capital.
Certain business types will have a higher working capital requirement than others. Retailers, farmers, wholesalers and manufacturers, for example, all have physical inventory and often require a lot more working capital for these operations. On the other hand, businesses that provide intangible services, like consultants or online designers, generally have much lower working capital needs. Additionally, mature businesses that have already gone through their growth phase and are no longer looking to grow rapidly won’t have high working capital needs.
Many businesses that are seasonal in nature will have much higher working capital requirements during certain periods of the year as they prepare for their busy season. The length of a business’ operating cycle can also have an effect on how much working capital they need. Businesses that take longer to produce and sell a product will need more working capital in the interim periods, as will businesses that have customers that cannot make payments on time.
Understanding all the different factors that can affect your business’ working capital needs is the first step to managing healthy finances. If your business is seasonal, anticipating when you may need a cash injection and how much can help smooth out period of rocky working capital. If you have customers or clients that are behind in their repayments, then you may need to adjust spending to compensate for a period of cash shortage until the payments come through.
Even if your business is looking to expand or grow rapidly, your business will have increased capital needs on top of any funds dedicated to expansions (i.e. new shop, equipment etc.).
Working Capital Solutions
A recent report done by Digital Finance Analytics found that around 60% of SMEs are looking to borrow and that most are looking for working capital support. Drilling down further, the report found that the main driver for this was delayed payments (particularly from large private sector companies and government agencies). It also found that the average debtor period is more than 50 days and is rising.
Xero’s Small Business Insights (a report that analyses business data from across Australia) found that at least half of all Australian SMEs are cash flow negative throughout the year. This number varies a bit throughout the year but more businesses are cash flow negative in the months leading up to Christmas and into January.