SmallBusiness.wa.gov.au
The Small Business Specialists
Phone: 131 BIZ
Website: www.smallbusiness.wa.gov.au
Working capital 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.
It is important you work out the right level of working capital you will need. If the working capital is too high, your business has surplus funds which are not earning a return. However, a working capital that is too low may indicate that your business is facing financial difficulties.
The right level of working capital depends on the industry and the particular circumstances of the business. For some businesses there could be a substantial length of time to make and sell the product, then actually collect the cash from your customers. These businesses will need a high level of working capital to survive.
Other businesses that only sell services, such as accountants or consultants, do not need to pay out cash for inventory. Others may receive their cash very soon after, or perhaps even before, paying suppliers for inventory. These businesses will need a lower level of working capital.
The Working Capital Cycle refers to the time it takes to purchase inventory or components to making the sale and receiving the cash.
Working capital is made up of three core components in the cycle:
The key to successful cash management is to be in control of each step in the cycle. The faster you can convert your trading operations into available cash means you will have increased the liquidity in your business and will be less reliant on cash from customers, extended terms from suppliers, overdrafts, and loans.
You need enough working capital to provide a safety margin in case sales fall, customers are late in paying you, or unexpected expenses arise. Your working capital level will generally need to increase when going through a period of growth and expansion.
Having negative working capital (where current liabilities are greater than current assets )is a danger sign and means your business is having difficulties meeting its short-term commitments and will not survive without urgent corrective action.
To work out whether your business has enough working capital, you will need figures from your most recent balance sheet. Use the following formula to calculate the level of working capital for your business:
This calculation will result in an absolute dollar value for your working capital but does not give you a sense of whether your working capital safety margin is wide enough. The working capital ratio (also called current ratio , liquidity ratio) will give you a better measure of liquidity – the ability of your business to pay its bills.
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, a 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.
This method is useful for businesses going through a period of growth and expansion to work out how much extra working capital you need if turnover increased by a certain amount.
You will need figures from your most recent balance sheet and profit and loss statement.
The formula used to calculate an estimate of working capital as a percentage of sales for your business is:
and:
