The idea of working capital tends to be misunderstood by many small business owners. A useful tool for determining your working capital needs analyzes your accounts receivable, inventory and accounts payable cycles in terms of days – the “operating cycle”. Most businesses cannot afford to operate without short term funds, so knowing the various scenarios associated with how and when working capital can be used will help owners navigate their business cycle.
The amount of working capital needed by any given business is determined by a number of factors: type of business; stage of growth or contraction; and amount of support one gets from the business’s vendors (supply chain) regarding accounts payable and accrued expenses. In a manufacturing business, one will have to buy inventory, manufacture it, sell it, and collect on the accounts receivable. Often times, the payment for the raw material is due either COD or net 30 days. Depending upon the product, it may take days to weeks or months to manufacture, sell, and again, depending upon the type of sales network, it can often take 30 to 90 days to collect receivables.
In a software business, in the initial stages, one typically thinks more of burn rates as the business is being developed and the product made ready for the marketplace. Once the product is available in the marketplace, many of the same issues as the manufacturing company would be applicable. In a more service-oriented business, one often has the luxury of not needing as much working capital as there would not be inventory to be purchased, developed, and sold. However, as one scales a consulting business, the need for working capital for the payment of salaries becomes greater over time.
In a business which is growing, the need for working capital is greater than one that is stable, and many businesses who are experiencing the most success often get “tripped up” because their need for working capital financing is greater during this phase. It may seem counter-intuitive, but in the early stages of the contraction of the business, one often sees an influx of cash and the working capital requirement is lessened so long as one has not purchased substantial inventories in anticipation of sales which did not materialize.
The need for working capital can be lessened substantially if one receives extended terms from the company’s vendors and therefore has the luxury of waiting to sell its product and receive payment, prior to paying its vendors. The ratio of short-term assets to short-term liabilities is often referred to as working investment, and this can substantially lessen the need for working capital. One of the more bizarre examples of this was an aerospace company that had suffered the loss of half of its manufacturing capability as a result of a fire. The customers actually extended a loan to the company, and prepaid for the materials, to keep it in business when the banks would not, and the company was able to get back on its feet. This resulted in the company having a long-term liability to its customers, which it paid off over the next 3 years as it delivered the product resulting in revenue for the company, which was paid off by the loan cancellation.
As one can see, the amount of working capital needed varies by the type of business and stage of growth of the business, as well as the overall conditions of the economy in which the business operates.