Want to learn more about working capital?
‘Working Capital’ and ‘Cash flow’ may sound similar to some, but understanding the difference can have a bearing on business success, especially in a changing environment e.g. growth or downturn.
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.
Cash flow – What is it?
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
- Work in Progress
- Outstanding customer amounts
- Outstanding supplier amounts
How to calculate ‘Working Capital Requirement’
One simple way to calculate your ‘Working Capital Requirement’ is as follows
Formula: Working Capital % = (Outstanding Customer Amounts + Work in Progress or Stock – Outstanding Supplier Amounts)/Revenue x 100
Example – A business has the following
- Outstanding Customer Amounts of $150,000
- Work in Progress of $300,000
- Outstanding Supplier Amounts of $100,000
Revenue of $1,000,000
The calculation of working capital requirement here would be
($150,000+$300,000-$100,000)/$1,000,000×100 = 35.00
This means that for every one hundred dollars of sales in this business $35.00 is required to fund the sale i.e. to allow for the time stock sits in store
- customers are taking to pay
- work is in progress prior to invoicing
- the business is taking to pay its suppliers
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
- 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 the above objectives you need systems and processes in place to constantly manage these factors and minimise working capital requirement.
Avoid the traps.
A common misunderstanding, is that if a business sells more, working capital will take care of itself. A problem arises when these factors are not managed and the cash gets tied up in stock, work in progress, customers and suppliers etc. Funds become scarce to pay costs such as wages, superannuation and other overheads.
There are 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 didn’t equate to extra cash in the bank immediately. The moral here is to think very carefully before you make instant buying decisions. Consider the extra working capital required to fund that business before taking it on.
A common trap business owners fall into is focusing on sales and profit without considering working capital. High working capital requirement will bring a business undone far quicker than low profit margins.