Ending Soon! Save 33% on All Access

Working Capital Analysis Take stock of your working capital to make sure your business can meet its financial needs.

Working capital is one of the most difficult financial conceptsto understand for the small-business owner. In fact, the term meansa lot of different things to a lot of different people. Bydefinition, working capital is the amount by which current assetsexceed current liabilities. However, if you simply run thiscalculation each period to try to analyze working capital, youwon't accomplish much in figuring out what your working capitalneeds are and how to meet them.

A useful tool for the small-business owner is the operatingcycle. The operating cycle analyzes the accounts receivable,inventory and accounts payable cycles in terms of days. In otherwords, accounts receivable are analyzed by the average number ofdays it takes to collect an account. Inventory is analyzed by theaverage 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 convertedto cash or an account receivable). Accounts payable are analyzed bythe average number of days it takes to pay a supplier invoice.

Most businesses cannot finance the operating cycle (accountsreceivable days + inventory days) with accounts payable financingalone. Consequently, working capital financing is needed. Thisshortfall is typically covered by the net profits generatedinternally or by externally borrowed funds or by a combination ofthe two.

Most businesses need short-term working capital at some point intheir operations. For instance, retailers must find working capitalto fund seasonal inventory buildup between September and Novemberfor Christmas sales. But even a business that is not seasonaloccasionally experiences peak months when orders are unusuallyhigh. This creates a need for working capital to fund the resultinginventory and accounts receivable buildup.

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

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

  • Equity: If your business is in its first year ofoperation and has not yet become profitable, then you might have torely on equity funds for short-term working capital needs. Thesefunds might be injected from your own personal resources or from afamily member, friend or third-party investor.
  • Trade Creditors: If you have a particularly goodrelationship established with your trade creditors, you might beable to solicit their help in providing short-term working capital.If you have paid on time in the past, a trade creditor may bewilling to extend terms to enable you to meet a big order. Forinstance, if you receive a big order that you can fulfill, ship outand collect in 60 days, you could obtain 60-day terms from yoursupplier if 30-day terms are normally given. The trade creditorwill want proof of the order and may want to file a lien on it assecurity, but if it enables you to proceed, that shouldn't be aproblem.
  • Factoring: Factoring is another resource for short-termworking capital financing. Once you have filled an order, afactoring company buys your account receivable and then handles thecollection. This type of financing is more expensive thanconventional bank financing but is often used by newbusinesses.
  • Line of credit: Lines of credit are not often given bybanks to new businesses. However, if your new business iswell-capitalized by equity and you have good collateral, yourbusiness might qualify for one. A line of credit allows you toborrow funds for short-term needs when they arise. The funds arerepaid once you collect the accounts receivable that resulted fromthe short-term sales peak. Lines of credit typically are made forone year at a time and are expected to be paid off for 30 to 60consecutive days sometime during the year to ensure that the fundsare used for short-term needs only.
  • Short-term loan: While your new business may not qualifyfor a line of credit from a bank, you might have success inobtaining a one-time short-term loan (less than a year) to financeyour temporary working capital needs. If you have established agood banking relationship with a banker, he or she might be willingto provide a short-term note for one order or for a seasonalinventory and/or accounts receivable buildup.

In addition to analyzing the average number of days it takes tomake a product (inventory days) and collect on an account (accountreceivable days) vs. the number of days financed by accountspayable, the operating cycle analysis provides one other importantanalysis.

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

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, agood understanding of working capital is imperative to make anyventure successful.

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

Want to be an Entrepreneur Leadership Network contributor? Apply now to join.

Business News

Apple iPhone 7 Users May Be Owed a Slice of a $35 Million Settlement — Here's How to Claim Your Share

Previous (and current, no judgment) iPhone 7 users may be entitled to up to $349. The deadline to file a claim is June 3.

Business Ideas

63 Small Business Ideas to Start in 2024

We put together a list of the best, most profitable small business ideas for entrepreneurs to pursue in 2024.

Business News

Did OpenAI steal Scarlett Johansson's voice? 5 Critical Lessons for Entrepreneurs in The AI Era

Did OpenAI steal Scarlett Johansson's voice? OpenAI has since paused the "Sky" voice feature, but Johansson argues that this is no coincidence. In response, Johansson delivers a masterclass for entrepreneurs on navigating the AI era successfully.