Although the conventional formula for calculating working capital involves deducting liabilities from assets, it’s important to determine what your business needs compared to what you actually have.
More often than not, additional cash flow is necessary for purchasing new equipment, upgrading existing equipment, meeting payroll, launching marketing campaigns and purchasing inventory. Here are some additional factors to consider when determining how much working capital your business may actually need.
When performing a working capital analysis, your goal is to take a pulse of the assets available along with the outstanding liabilities at that given moment. However, a more realistic picture of your situation should take into consideration your operating cycle.
Turnaround time plays an important role in analyzing your financial picture. Look at the average number of days it takes to collect payment on an account (Past payment history can give you a good idea of this). Likewise, your inventory should be measured based on sales. How long does it take a product to leave the shelf and convert to cash? Underlying factors such as these give a more accurate estimate to available working capital.
The type of business you have will also help to determine your unique working capital needs. For example, running a retail business will bring periods of time where working capital will be needed to finance new inventory for pre-determined sales peaks. According to The National Retail Foundation, the holiday season can represent as much as 30 percent of annual sales.
Additionally, you may have other non-holiday periods where there is a periodic spike in sales. If you do not have a strong cash reserve to cover new inventory for these periods, consider a working capital loan to ensure you have enough products to meet customer demand.
Some businesses need working capital in order to meet long-term goals. If you’re like most business owners, you'll have goals on where you wish to see your business in say 3 years, 7 years, etc. How exactly will you accomplish these goals?
Additional cash flow may be needed in order to fuel your company's growth. As many business owners have discovered, you have to spend money to make money. On the other hand, that doesn’t mean to take on a loan too big for your business. You always want to come up with a repayment plan in order to ensure you do not dig your business into too deep of debt.
The Bottom Line
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