Managing working capital ensures a company has the cash flow to continue day-to-day business operations. A working capital analysis provides information on the company’s financial position. For example, companies with a larger amount of working capital experience less financial stress during difficult periods or times of high customer orders. All companies have permanent working capital requirements, while some businesses also experience temporary financing requirements.
Working Capital Calculation
Companies calculate working capital by subtracting liabilities from assets. The amount left over is the capital the business has available to fund operations. Assets include inventory and accounts receivable. Further analysis of the business operating cycle determines the company’s working capital needs. For example, the business must analyze accounts receivable in terms of the days required to receive payment from customers. Inventory analysis determines the amount of time it takes to convert product into an accounts receivable or cash for the business. Analysis of company liabilities examines the number of days the business requires to pay outstanding invoices.
Companies with permanent working capital needs require additional financing to fund the gap between the time it takes to convert assets to cash and liability payments. According to Entrepreneur, most businesses require financing to fund the operating cycle. Permanent working capital needs exist when the time required to convert assets to cash exceeds the time allowed to pay accounts payable. The business requires additional working capital to fill the gap.
Businesses may require additional working capital only at some points during the year. For example, during the holiday season a retail business may require additional funds to pay for extra inventory and additional staff. Not all temporary working capital needs are the result of seasonal expenses. For example, a company that experiences a period of high customer orders may require temporary working capital.
Businesses can fund working capital needs through multiple sources. For example, a business may work with vendors to extend payment terms for an unusually large order. The vendor may require proof of the order as security for credit extension, and some vendors will file a lien against the order to ensure payment. A line of credit or short-term loan can also fund temporary working capital needs during periods of unusually high customer orders.