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Working Capital Analysis

Take stock of your working capital to make sure your business can meet its financial needs.
April 20, 2006
URL: http://www.entrepreneur.com/article/21940

Working capital is one of the most difficult financial concepts to understand for the small-business owner. In fact, the term means a lot of different things to a lot of different people. By definition, working capital is the amount by which current assets exceed current liabilities. However, if you simply run this calculation each period to try to analyze working capital, you won't accomplish much in figuring out what your working capital needs are and how to meet them.

A useful tool for the small-business owner is the operating cycle. The operating cycle analyzes the accounts receivable, inventory and accounts payable cycles in terms of days. In other words, accounts receivable are analyzed by the average number of days it takes to collect an account. Inventory is analyzed by the average number of days it takes to turn over the sale of a product (from the point it comes in your door to the point it is converted to cash or an account receivable). Accounts payable are analyzed by the average number of days it takes to pay a supplier invoice.

Most businesses cannot finance the operating cycle (accounts receivable days + inventory days) with accounts payable financing alone. Consequently, working capital financing is needed. This shortfall is typically covered by the net profits generated internally or by externally borrowed funds or by a combination of the two.

Most businesses need short-term working capital at some point in their operations. For instance, retailers must find working capital to fund seasonal inventory buildup between September and November for Christmas sales. But even a business that is not seasonal occasionally experiences peak months when orders are unusually high. This creates a need for working capital to fund the resulting inventory and accounts receivable buildup.

Some small businesses have enough cash reserves to fund seasonal working capital needs. However, this is very rare for a new business. If your new venture experiences a need for short-term working capital during its first few years of operation, you will have several potential sources of funding. The important thing is to plan ahead. If you get caught off guard, you might miss out on the one big order that could have put your business over the hump.

Here are the five most common sources of short-term working capital financing:

In addition to analyzing the average number of days it takes to make a product (inventory days) and collect on an account (account receivable days) vs. the number of days financed by accounts payable, the operating cycle analysis provides one other important analysis.

From the operating cycle, a computation can be made of the dollars required to support one day of accounts receivable and inventory and the dollars provided by a day of accounts payable.

Working capital has a direct impact on cash flow in a business. Since cash flow is the name of the game for all business owners, a good understanding of working capital is imperative to make any venture successful.

Excerpted from Start Your Own Business: The Only Start-Up Book You'll Ever Need, by Rieva Lesonsky and the Staff of Entrepreneur Magazine, © 1998 Entrepreneur Press