Understanding the Working Capital requirements of your Business
Working Capital is a critical issue at any time in business and especially when your business is growing, there’s a downturn or changed circumstances with your suppliers and the market.
Working Capital Requirement – What is it?
In simple terms working capital requirement is the amount of funds required by a business to meet its short-term obligations i.e. the next twelve months.
How Working Capital differs from Cash flow
Working Capital and Cashflow are often confused with each other. Cashflow is the amount of funds available in the business to meet its future obligations.
The key words above are ‘required’ and ‘available’. The difference between the two can be vast and cause funding headaches if not properly managed and considered.
Working capital requirement is affected by the management of several factors in a business:
How can you calculate your Working Capital Requirement?
Calculating Working Capital % Requirement:
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Outstanding Customer Amounts + Work in Progress or Stocks - Outstanding Supplier Amounts
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x 100 |
Revenue |
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Example:
The calculation of working capital requirement here would be:
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150,000 + 300,000 - $100,000
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x 100 |
= 35% |
1,000,000 |
|
|
This means that for every sale of $100.00 in this business, $35.00 is required to fund the sale.
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To allow for the time:
Strategies to Minimise Working Capital Requirement
The way to minimise working capital requirement is:
- Stock – aim to minimise the length of time it sits on the shelf sucking up cash
- Work in Progress – aim to minimise the length of time jobs are in progress prior to invoicing or arrange to invoice a job progressively
- Outstanding customer payments – aim to minimise the length of time customers take to pay
- Outstanding supplier payments – aim to maximise the length of time available to pay suppliers
To meet these objectives you need systems and processes in place to constantly manage these factors and minimise working capital requirement.
Why selling more is not the answer!
Sell more and that will provide the working capital?
A common fallacy is that if a business sells more, working capital will take care of itself. A problem arises when the abovementioned factors are not managed and the cash gets tied up in stock, work in progress, customers and suppliers etc. You can then have difficulty paying costs such as wages, superannuation and other overheads.
We've seen many examples where a business was purchased for what seemed like a good price, and the issue of working capital requirement was completely ignored. The purchaser gets a rude shock when the extra business doesn’t equate to more cash in the bank. The moral here is to think very carefully before you take on extra business or buy a competitor. Consider the extra working capital required to fund that business before taking it on.
A common trap SMEs fall into is focusing on profit without considering working capital. High working capital requirement will bring a business undone far quicker than low profit margins.
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