How Much Working Capital is Needed to Grow Your Small Business?
How Much Working Capital is Needed to Grow Your Small Business?
Every business needs funds for its growth and expansion. Working capital is a crucial financing tool that helps a business’s day-to-day operations. Experts have defined it as the difference between a particular business’s current assets and current liabilities. This metric helps one determine a company’s growth potential and competency.
Businesses, especially MSMEs, need to determine how much funds they need to maintain their operations even in unforeseen circumstances. This blog focuses on important details that an enterprise should consider while assessing and calculating its working capital needs.
Factors to Consider while Assessing Working Capital Needs for a Small Business
The following are some of the essential factors to consider when deciding the working capital requirements of a particular business:
Business Model
Working capital requirements would depend on the business model. For instance, a business that relies on heavy inventories and requires a longer period for processing would invariably need more working capital. However, an entirely service-oriented business would need only enough capital for smooth operations.
Working capital needs of a business might also depend on seasons if the business deals with products that are related to seasonality. For example, businesses that sell air conditioners might need a higher inventory before summer. In such cases, these businesses should make arrangements for a higher working capital loan during the specific season when it makes the most sales.
Growth Plans and Stage
Businesses that have been newly established may require higher working capital for growth and development, unlike established companies that have a steady revenue stream. In such instances, business owners must examine their financing requirements after assessing their growth and expansion plans and working capital positions.
Working Capital Cycle/Business Cycle
One has to consider the time difference between the revenues and expenses. Businesses should note that time difference is directly proportional to working capital need, i.e. higher the difference in time, the higher would be the working capital need.
How Much Working Capital is Needed by a Business?
A business owner needs to carefully forecast how much working capital his/her business needs. To calculate the working capital needs, one needs to consider the above-mentioned factors as well as other factors like its size, type of business activity and turnover rate.
All businesses need sufficient working capital; otherwise, they would not be able to continue their operations. However, having too much working capital can be counterproductive as well. While it would allow the firm to pay its obligations, the funds would not generate the income required for its growth.
One must ensure that a company has some reserve funds required for unexpected situations. Having quick access to additional working capital also allows a company to capitalise on growth opportunities.
The following sections will describe how to calculate a business’s working capital needs.
How to Calculate Annual Turnover Rates of a Business?
Given below are the steps to calculate:
Step 1: Divide ‘average accounts receivable’ by ‘annual sales’ and multiply it by 365 to get the ‘accounts receivable turnover days.’
Step 2: Next, divide the average inventory by ‘annual COGS’ (Cost of Goods Sold) and multiply it by 365 to get ‘inventory turnover days.’
Step 3: Divide ‘average accounts payable’ by annual purchases and multiply it with 365 to receive the ‘accounts payable turnover days’.
After one completes calculating the turnover rates of a business, it’s time to consider the expansion plans and calculate the working capital needs. To do this calculation, one would need a projected income statement, including the cost of goods sold and projected sales.
So, to calculate working capital needs, one would need the following data:
- Accounts Receivable Turnover Days
- Inventory Turnover Days
- Accounts Payable Turnover Days
- Projected Sales
- Projected Purchases
How to Calculate Working Capital Needs?
One needs to follow these steps to calculate the required working capital:
Step 1: Calculation of Projected Working Capital
- Divide ‘projected sales’ with 365 and multiply it with ‘accounts receivable turnover days’ to receive the ‘projected accounts receivable.’
- Then, divide ‘projected COG’ (Cost of Goods) with 365 and multiply it with ‘inventory turnover days’ to receive the ‘projected inventory.’
- After this, divide ‘projected purchases’ with 365 and multiply it with ‘accounts payable turnover days’ to get the ‘projected accounts payable.’
Step 2: Calculation of the Increase from Historical Working Capital
- Subtract ‘historical accounts receivable’ from ‘projected accounts receivable’ to get the ‘change in accounts receivable.’
- Deduct ‘historical inventory’ from ‘projected inventory’ to get ‘change in inventory.’
- Subtract ‘historical accounts payable’ from ‘projected accounts payable’ to get ‘change in accounts payable.’
Step 3: Calculation of New Working Capital Needs
To receive ‘working capital needs, one needs to add up ‘change in accounts receivable’ with ‘change in inventory’ and subtract ‘accounts payable’ from the amount. The formula is illustrated below:
(Change in accounts receivable + change in inventory – change in accounts payable)
Reasons Why a Small Business Might Need Additional Working Capital
The following are some reasons for a small company to need more working capital:
- Businesses might face sudden cash crunches and fail to meet commitments to suppliers and employees. They might even fail to pay taxes because customers fail to make payments. This is when working capital might bail them out.
- A business might need working capital for project-related expenses and for paying temporary employees.
- Extra working capital will prove to be beneficial for availing supplier discounts while one places an order in bulk.
- Small businesses might face seasonal differences in cash flow. In such cases, extra working capital is the perfect solution to keep running the business.
Fintech service providers like KredX offer working capital solutions in the form of invoice discounting. Its transparent policies, cutting-edge technology and hassle-free procedures enable businesses to solve their working capital needs smoothly.
Bottom Line
To sum up, a business needs to assess and calculate its working capital needs to meet its potential. Small businesses face such problems accessing working capital due to their lack of assets for collateral and credit history. However, there are many working capital finance options like invoice discounting that can help in this regard.
