How to Determine the Amount of Working Capital Your Business Needs
By the end of this post, you’ll understand how each one of these factors affects your working capital needs.
Type of Business: Seasonality and Operating Cycle
Accounting Tools defines the operating cycle of a company as:
“The average period required for a business to make an initial outlay of cash to produce goods, sell the goods, and receive cash from customers in exchange for the goods.”
The type of business you run and your operating cycle go hand in hand. The key difference is that the “time required for a business to receive cash from customers,” may vary quite a bit even between similar businesses.
Seasonality of Sales
The type of business you run is also important because working capital needs may vary depending on seasonality. For example, a retail store might not need a lot of money to pay for new inventory during the summer. Then, when the holiday season arrives, they’ll need to make large inventory purchases to capitalize on holiday sales. Recognizing seasonality will allow you to determine the fluctuating amount of working capital your business entails.
Your business’s operating cycle will majorly affect how much working capital you’ll need. For instance, consider the differences in terms of working capital needs between a wholesaler and their client, a fast food restaurant. The fast food restaurant will order meat, potatoes, soft drinks, and any other ingredients they need to prepare menu items. But, conceivably, the fast food restaurant owner could order a shipment, receive it a week later, and sell it the next day.
On the other hand, a wholesaler spends money on producing goods that may not be paid for until months later. Sometimes, they may only receive payment upon a customer’s receipt of the product. If that product has to be shipped across the country, and then payment isn’t due until a month later, that business owner won’t have that cash for a fairly long time.
In this example, you can see why the wholesaler would need a larger amount of working capital during that time than the fast food business owner. The wholesaler simply can’t generate cash quickly enough to afford all his expenses, so he’ll need a larger safety net.
Your Goals as a Business Owner
Your goals, particularly as they relate to investing in your business, play a large part in determining your business’s working capital needs. For example, one business owner may be completely fine with having $100,000 in unused cash, while another might consider that amount to be too much. That’s because it depends on how much you want to invest in growing your business. In this case, it’s not a matter of “right” or “wrong,” it’s just a personal preference.
Operational Efficiency, Other Costs, and Payment Cycles
Small nuances in the way you do business make your needs unique. For example, you may have special taxes to pay or regulations to follow. Additionally, the timelines of when you receive payment for goods and services can affect your working capital needs. For these smaller reasons, you’ll have to be aware of all the small details of your business to be accurate when estimating working capital needs.
Evaluating working capital needs will give you great insight into if your business is operating efficiently. Plus, you’ll gain clarity on where you need to cut back and where you can afford to spend surplus capital to grow your business.
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