All small business owners, regardless of industry and employee count, need to understand their company’s working capital cycle, or the amount of time it takes from producing a product or service to receiving payment for that product and service. The longer the cycle, the longer a business is tying up capital without receiving cash to further invest, or pay obligations.
Fully understanding all components of your cycle is a matter of business viability, as it allows you to better manage your cash flow. It’s also an excellent indicator of your company’s efficiency and short-term financial health – positive cash flow is a sign that a business is well-positioned for expansion, growth or acquisition.
How to Calculate Working Capital
Working capital is calculated by taking current assets (accounts receivable, cash and equivalents, and any inventory) minus current liabilities (including accounts payable). When a business’s assets are less than its liabilities, there is a working capital deficiency, but it’s also possible to have significant working capital and still have a cash flow problem because of a lack of liquidity within current assets.
Your working capital ratio can be calculated by dividing current assets by current liabilities. If that number is less than 1.0, this indicates a negative working capital position with too few current assets to cover short-term liabilities. On the flip side, a ratio above 2.0 could indicate poor capital management (too much finished inventory, too much cash in the bank and not invested, aging receivables). An ideal range for the ratio is between 1.2 to 2.0; this indicates that the company should be able to cover ongoing cash requirements and has “wiggle room” for things like unplanned maintenance requirements or inventory build to support new business.
An important benchmark in determining a business’s cash needs is understanding the operating cycle, or the amount of time it takes for a business to turn cash used to create inventory back into cash again. The operating cycle looks at accounts receivable, inventory and accounts payable in terms of days – days to collect on a receivable and turn it into cash, days it takes to turn inventory into a sale, and days a business may take to pay supplier invoices. The goal of every business is to be able to fully finance the operating cycle with accounts payable financing alone. At a minimum, you should have three months’ worth of working capital available.
How to Manage Working Capital
In cases where there’s a working capital deficiency, a business may be able to shorten its cash conversion cycle by reconfiguring its accounts receivable, inventory management and accounts payable practices to shift their timing and, thus, the amount of working capital on hand. In all cases, it’s a matter of the business’s ability to convert those components into cash, which could take the form of cash flow management:
- Requiring or offering incentives – such as an early payment discount – to accelerate the receipt of accounts receivable in 10 days instead of 30, for example
- Hiring someone part-time to aggressively tackle outstanding account receivables by calling customers and securing payment
- Waiting to pay on accounts payables that allow for a 45-day window for payment until closer to the 45 days instead of 30 days
- Embracing a “just in time” inventory practice so inventory doesn’t sit around (not producing income) or risk becoming obsolete
Cash conversion cycles will vary by industry; manufacturers, for instance, typically have much longer cycles than service-based businesses. For some, working capital might be a seasonality issue, such as retailers who need to expand inventories significantly during the holiday season and turn it back into cash quickly, since inventory held after Christmas often has to be heavily discounted.
How to Bolster Working Capital
There are several approaches for addressing a working capital deficiency, including an injection of cash by the owner. A shortfall could also be covered by tapping into company equity (if a business has grown to that level), cutting overhead expenses or implementing manufacturing cost improvements through technology or process innovations. Most growing businesses cannot completely finance the operating cycle (accounts receivable days plus inventory days) with accounts payable financing alone. More times than not, particularly in small businesses experiencing growth, the right commercial loan products can be the smartest way to fulfill an operating shortfall. There are two common lending products that can bridge this gap:
- A short-term loan is usually paid in one year or less, depending on the amount borrowed and the business’s financial situation. Short-term loans are often used for large, specific expenditures that include a significant delay in receipt of the payment. Example: A manufacturer may land a contract to build a significant piece of capital equipment that requires 12-18 months to complete, deliver and install. In that case, an 18-month short-term loan makes sense because it can then be paid in full when the manufacturer receives payment.
- A line of credit (LOC), if used appropriately, funds the gap between when a business pays its vendors and when it, in turn, is paid by its customers. Lenders will analyze businesses’ working capital cycle, their operating margins, the stability of current customer relationships, and their ongoing sales and marketing efforts to determine the most appropriate line of credit level. A line of credit should always be viewed as a seasonal bridge. Difficulty regularly paying down LOC is an obvious indicator of more troubling working capital challenges.
As you can see, there’s good reason the saying “cash is king” is a popular business mantra and easy to see why smart working capital management plays a crucial role in ensuring a business has the cash flow it needs to remain viable.
Helping to improve your working capital management is just one of many ways an experienced business banker can help position your company for profitable growth. To learn more about all the ways he or she can contribute to your success, download our ebook, 8 Ways Your Banker Can Impact Your Business now!