What Is Working Capital and How Does It Affect Business Cycles?
Working capital seems simple enough. It’s about having enough cash to pay your bills when they’re due, right? True, but if you stop there and think you’re done, you’re falling into a classic trap.
Beyond the basics, you need to understand the underlying financial concepts behind working capital. Then, you need to be prepared to take market shifts and demand fluctuations into account when creating a strategy that lasts.
Having a well thought out plan is truly essential if you’re going to handle changes in your working capital. And creating that strategy starts with the fundamentals.
What Is Working Capital?
You can define it as an asset or sum of assets, but that’s missing the big picture as only certain assets are considered working capital.
Whether an asset is considered WC is defined by its ability to be used as a payment currency for your daily expenses.
- Cash is an asset and it can also be used to purchase inventory, run logistics and pay your employees.
- Real estate and equipment, while being assets, are not necessarily working capital. They probably affect your sales revenue, but unless you sell or lease them, you won’t be able to fuel your everyday operations.
The Working Capital Equation
If you take your current assets (CA), then subtract your current liabilities (CL), what’s left is essentially your working capital (WC).
It looks like this: WC = CA – CL
Cash is an important part of your current assets. Take good care of it.
The first step to calculate your WC is to create a balance sheet account summing up the value of all assets expected to be converted into liquid funds. Current assets include:
- Inventory (Unsold Stock)
- Pre-paid expenses
- Debtors (Customers who haven’t paid you yet)
Then, list all of your debts and obligations that are due. They may include:
- Account Overdrafts
- Creditors (Suppliers who you haven’t been paid yet)
- Accrued Liabilities
- Various Forms of Debt
Liquid Assets Keep Your Business from Drowning
You need liquid assets to run your business. More liquidity means a more agile and responsive business. That’s why understanding your working capital ratio (WCR) is so important. It allows you to evaluate your liquidity.
WCR = Net Working Capital / All Your Assets
If the total worth of your assets is 1 million dollars (real estate, vehicles, equipment, inventory, cash etc) and your WC (liquid or near liquid assets) is $500,000, then your WCR would be:
$500,000 / $1,000,000 = 0.5 (50%)
That’s a very high percentage, and means the business in question is well equipped to handle any sudden market shifts. However, a high percentage of liquidity is not always a good thing. You don’t want to have idle liquid capital that you’re not using (be it to pay your bills or re-invest in your growth).
The key is finding a balance that works for your business. That means understanding the business cycle.
Understanding Business Cycles
The definition of “business cycle” is fairly simple: the time required for a product to be produced or purchased, then sold, profits collected, and money transferred to the bank. But again, that simplicity can be deceiving, as the there are many factors at play.
For example, working capital is directly affected by the length and specifics of the business cycle.
That’s because invoice collection can stretch out over time. This is especially true for companies dealing with longer business cycles. Timing is essential as delayed payments can lead to dangerously low amounts of working capital.
Even if you’ve completed a highly profitable deal that will bring a lot of revenue next month, you still need cash today to run your business. Future money just doesn’t pay today’s bills.
Business cycle components
There are three main components that factor into business cycles:
- Accounts payable: defined by the average number of days it takes to pay a supplier’s invoice.
- Inventory: defined by the average number of days it takes to fully close a sale (turn your inventory into profit).
- Accounts receivable: defined by the average number of days it takes to collect an account.
Most new businesses have a hard time fully financing their operating cycles. Relying on accounts payable financing alone rarely provides sufficient working capital. This is mainly due to delays in closing sales and receiving payments. These delays can add up and cause real damage to your business.
How to maintain a healthy level of working Capital
Maintaining a healthy level of working capital is essential to keeping your business secure. There are two main strategies to do this:
- While waiting for your invoices to be paid, tap into your net profits to cover your ongoing expenses (provided you have funds saved up).
- Access external capital.
A mixed approach combining these methods is also not uncommon. In general, unless a company has an abundance of cash or their business cycle is relatively short, the first model is unsustainable. That’s why understanding how all of these factors apply to your business is key.
At some point, most companies need additional working capital financing to maintain growth or simply to survive. It’s a simple reality of working in a globalized economy with complex and long business cycles.
Increased demand for WC could be due to:
- Seasonal peaks where additional capital is needed for inventory build-up or to assemble extra work force.
- Unusual peaks in orders when a sudden increase in the scope or volume of orders, that exceeds your nominal delivery capacity.
- Internal crisis where there’s a loss of working capital due to poor working capital management, accounting errors, theft of stock, natural disasters, investments pulled out of the business, etc.
- Growth opportunities when a competitor files bankruptcy and you have a chance to claim their market share by expanding your scope of operations. Other reasons could be new technologies or strategies that could give you an edge in your niche.
Large corporations and some companies may have enough cash reserves to handle such scenarios. But for most businesses the only possible solution is to borrow external assets.
Read this article to learn about how to increase your working capital.
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