Learn What Working Capital is and How to Manage It
Cash flow relates to the amount of money your business earns over a period. In comparison, working capital is a current snapshot of how much cash a business has. In this post, we’ll explain why working capital is so important to the survival of any business.
What is Working Capital?
Working capital is the difference between current assets and current liabilities. Current means 12 months or less in duration for assets and liabilities.
If current assets are larger than current liabilities, the company has working capital.
Working capital is not the same as investment capital or long-term capital – which is used to fund large capital projects that can span years.
In addition, working capital can be used to pay for daily expenditures and purchase of raw materials to manufacture company products.
If the company is service-based and doesn’t manufacture any products, working capital is still used for daily expenditures but instead of purchasing raw materials, working capital is used to afford payroll and any other expenses needed to remain operational.
How Does the Operating Cycle Impact Working Capital?
Working capital is closely tied to the operating cycle, which is the time cash leaves the company, due to the production of products or services, to the time it is returned. This cycle is sometimes also referred to as the cash-to-cash cycle.
The operating cycle starts with cash leaving the company to purchase materials. There are numerous steps that occur during production and invoicing of customers. The cycle is completed when cash is returned through customer sales and remittance of payment. In-between cash leaving and returning to the company is where working capital becomes important.
Thomas Stewart, Executive Director at National Center for the Middle Market, had this to say about working capital, “In the ordinary course of business, [working capital is] money that you have tied up doing the things you need to do. If I’ve billed you, and I haven’t gotten paid yet, that is my money that is tied up waiting while the check is in the mail.”
The diagram below outlines the operating cycle:
Depending on the business, an operating cycle might last a few days or months. No matter how long it lasts, cash is always needed to fund the operating cycle.
During the operating cycle, daily expenses still must be paid. In addition, it’s imperative to ensure payroll is deployed on-time. There are many demands on short-term cash that must be met, or else your business might find itself in jeopardy of being shut down.
It’s critical that you appropriately manage your working capital, so that you have enough funds on-hand to cover costs throughout each operating cycle. We say “each” operating cycle because there can be more than one, depending on how your business is setup to handle production of products. Multiple operating cycles also add another layer of complexity to working capital management.
How Can You Improve the Operating Cycle?
Since the operating cycle must exist, how can a business manage working capital sufficiently to get through the operating cycle?
One method is to finance the operating cycle through equity. This can mean that the owners put up more capital. Alternatively, owners can apply for additional working capital in the form of a business loan.
Another technique is to request better terms from your suppliers. Since the operating cycle starts with suppliers (purchase of raw materials), if your company can have payment terms extended, it will shorten the operating cycle on the front end.
A factor that will complement better supplier terms is reducing customer payment terms. For example, instead of net 60, you might impose net 45 terms. This reduces the operating cycle on the back-end. Still, you should be careful when reducing customer payment terms.
Unless there’s something in it for the customer, they will likely resist. If you’re serious about this consider offering a small discount in exchange for earlier payment which can be a great incentive for your customers
Planning for operating cycles can help with better working capital projections. To create any type of operating cycle projection, it’s necessary to know how long an operating cycle lasts. Typically, operating cycles are measured in days.
Once you know how long your operating cycle lasts, you can calculate how much working capital will be available at the end of future cycles.
How Does Seasonality Affect Working Capital?
Businesses affected by seasonality require more working capital planning and discipline. For example, let’s say a business has a large spike in sales at the end of the year and during the summer months. This will create peaks and troughs of cash inflows throughout the year. How does a business deal with this type of cash flow volatility and manage the operating cycle at the same time?
During the end of the year when sales spike, working capital will be flush with cash. This should create more cash than the company needs during this same period. The company already knows there will be another sales spike during the summer.
During seasons of low sales, there might not be as many employees, and expenses are generally low, which allows the business to hoard cash. During this slow period, the business starts its operating cycle to create product inventory for the upcoming summer season. Cash is deployed and focused on funding the operating cycle.
By allowing cash to build up during peak sales seasons then deploying it on its operating cycle during slow seasons, the company able to successfully manage its working capital.
Conclusion: Understand Your Net Working Capital
Understanding and forecasting the operating cycle allows business owners to properly budget their working capital. Overall, it’s imperative to responsibly manage your working capital products so that your business can succeed.
Editor’s Note: This post was updated for accuracy and comprehensiveness in May 2019.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.