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Working capital is the money needed to fund the normal, day-to-day operations of your business. It ensures you have enough cash to pay your debts and expenses as they fall due, particularly during your start-up period.
Very few new businesses are profitable as soon as they open their doors. It takes time to reach your breakeven point and start making a profit.
Learn more about a breakeven analysis on the profit margin ratio page, or refer to Business Victoria’s margin, markup and breakeven information and templates.
The working capital cycle measures the time between paying for goods supplied to you and the final receipt of cash to you from the sale. It is desirable to keep the cycle as short as possible as it increases the effectiveness of working capital.
The working capital cycle is made up of four core components:
The key to successful cash management is to be in control of each step in the cycle. If you can quickly convert your trading operations into available cash, you will be increasing the liquidity in your business and will be less reliant on cash from customers, extended terms from suppliers, overdrafts, and loans.
If possible, always try to get paid up front. If you invoice up front you can avoid the cost of carrying others’ debts for months. For example, if your terms are 30 days and you invoice at the end of the month, customers have between 30 to 60 days to pay. You’ll also avoid losing money from bank charges, because you may be going into overdraft while you’re waiting to be paid.
The right level of working capital depends on the industry and the particular circumstances of the business.
Businesses that only sell services, and do not need to pay cash for inventory need a lower level of working capital. Businesses that take a substantial amount of time to make or sell a product will need a higher level of working capital.
It is important you work out the right level of working capital you will need. If the working capital is too:
The formula used to calculate working capital
Refer to balance sheet information before you get started, because you will need figures from your most recent balance sheet.
working capital ($ value) = current assets - current liabilities
This calculation does not give you enough information about your working capital margin of safety. To figure out if you have a wide enough margin of working capital for your business to be in a healthy position (in terms of liquidity) you need to calculate the working capital ratio (current ratio/liquidity ratio) of your business.
Most business owners have a clear idea of their weekly, monthly, or quarterly sales levels, so you may prefer to calculate how much working capital you need as a percentage of sales. For example:
The formula used to calculate an estimate of working capital as a percentage of sales compares the amount of working capital on the balance sheet to total sales, which you’ll get from your profit and loss (or income statement), not the balance sheet. Learn more about the profit and loss statement.
Working capital ($ value) = sales x (working capital as a % of sales)
Working capital as a percentage of sales of 35% means that you need $35 for every $100 of sales to fund the sale to allow for the time delay in the working capital cycle.
For businesses going through a period of growth and expansion, this method is good for calculating how much extra working capital you need if turnover increased by a certain amount.
The amount of working capital that’s enough for your business, depends on sales revenues, whether your business sells more services than products, if it carries high or low value stock, and any plans for growth.