Every business has its own working capital needs. Large companies more often have working capital lines of credit, allowing them flexibility to manage their working capital. For small businesses and newer companies, these lines of credit are rarely available, so it’s much more important to preserve working capital.
In this article, we’ll define working capital and explain how to figure out your business’ needs and whether you have enough working capital. We’ll also talk about how you can use equipment financing to preserve working capital.
What Is Working Capital?
Net working capital (NWC) is the difference between your company’s current assets and your current liabilities. You should be able to calculate your company’s working capital by taking the current assets and liabilities from your balance sheet and applying this formula:
Working capital = (Current assets) / (Current liabilities)
The figure you’ll get when you use this formula is called your current ratio. Another similar measurement is called a quick ratio. To calculate your quick ratio, consider only assets that you can convert to cash in 90 days or less. The quick ratio offers a more conservative view of your company’s ability to resolve short-term liabilities.
In general, when your assets add up to more than your liabilities, your current working capital is positive. When liabilities overtake assets, working capital becomes negative.
Why Working Capital Matters
Your company’s working capital can indicate whether you’re able to keep up with your short-term debt obligations. For example, let’s say your business has zero working capital. You’re keeping up with your financial obligations and day-to-day operating needs every month, so there’s no problem, right? But what happens if business suddenly slows down, and your revenue isn’t enough to meet your debt obligations? Now you need to dip into your working capital. And if you don’t have any, your company may be in trouble.
At Team Financial Group, we try to learn about every business we partner with to get the full picture of their health and challenges — we never reduce a business’ story to one number. But some analysts and financing partners like to rely on a few simple numbers when assessing a company’s health, and working capital can serve as one of those numbers. Working capital that’s negative or barely positive may signal to these analysts that your company is struggling to move inventory, taking on too many short-term expenses, collecting on bills too slowly, or paying debts too quickly.
Sometimes, a working capital crunch can even be a good thing. For example, periods of growth often lead to an increase in accounts receivable, which can reduce working capital. Growth is obviously a positive development on your business, but its effect on working capital still needs to be accounted for.
RELATED: 6 Ways to Better Manage Cash Flow
How Much Working Capital Do I Need, Exactly?
Many first-time small business owners want to know how much working capital they need. Without knowing any details about your business, it’s hard to provide an exact amount of working capital that you should aim for. Different types of businesses can have working capital needs that are worlds apart.
For instance, let’s say you run a consulting business that operates as a sole proprietorship out of your home. You have no employees, no inventory, and almost no operating expenses or overhead. In this case, your working capital needs might be almost zero.
On the other hand, imagine you run a family agricultural business here in Michigan that produces apples, cherries, and blueberries. You have employees, and your business depends on specialized, expensive equipment to operate. Not only that, but your cash flows become much smaller in the winter when nothing can grow. You’ll need enough cash to maintain equipment, pay bills, and service debts during your business’ slow season.
Consider Your Business Goals and Cash Conversion Cycle
Another factor that can affect your working capital needs is your set of business goals. If you’re looking to expand aggressively and move into new markets or product areas, you’ll need more working capital than a business that only wants to maintain what it’s doing.
Also, when you’re trying to figure out how much working capital you need, make sure to consider your cash conversion cycle (CCC), which is the time in days it takes for your company to convert inventory and other expenditures into cash.
To get a better picture of your cash conversion cycle, you’ll want to calculate your days of inventory outstanding (DIO), days sales outstanding (DSO), and days payable outstanding (DPO). DIO is the average number of days it takes your company to turn inventory into sales. DSO is the average number of days it takes your company to collect payment after making a sale. And DPO is the average number of days it takes your company to pay bills and invoices.
The formula for cash conversion cycle is:
CCC = (DIO) + (DSO) – (DPO)
For example, let’s say you run a woodworking business that makes custom tables and chairs. Starting from when you buy the wood, it takes, on average, 45 days to create a table or chair and sell it, so your DIO is 45 days. Then, it takes 30 days on average to receive payment from the sale, so your DSO is 30. Finally, it takes 15 days on average to pay bills and invoices, so your DPO is 15.
(45) + (30) – (15) = 60
In this case, your company’s cash conversion cycle is 60 days.
In general, the longer your cash conversion cycle, the more working capital you’ll need to keep your business healthy and stable.
How to Preserve Working Capital With Equipment Financing
Even if your company can get a working capital line of credit (LOC), making large purchases like equipment is probably not the best way to use it. Generally, a line of credit is used to fulfil working capital needs and the typical sales cycle. Most LOCs come with a variable interest rate and a monthly interest payment, with principal payments to be made throughout the cash conversion cycle of the business. Short term debt, such as inventory purchases and accounts receivable should be matched with short term borrowing such as LOC. Longer term debt should be used for equipment purchases to more closely match the life of the equipment.
When you need to purchase or upgrade equipment, you should explore your options for a term loan or lease. When you work with an independent financing partner like Team Financial Group, you may be able to get an equipment financing solution that’s customized based on your exact needs. There may also be some tax benefits from utilizing an equipment finance agreement or lease.
Partner With Team Financial Group and Get Fast, Flexible Financing Today
At Team Financial Group, we offer flexible payment terms tailored to meet your business needs. Our application process is easy and won’t affect your credit score, so apply today to get started.
If you have any questions about the financing application process or which financing option is right for your business, fill out our online contact form or call us at 616-735-2393. We’d love to chat with you about your options.
The content provided here is for informational purposes only. For financial advice, please contact our commercial financing experts.