Do you know how much working capital is required to run your business? The more money you are obliged to spend covering your obligations, the less money and flexibility you will have to seize opportunities, such as expanding your product line to meet new demand. In this article, we examine how to assess working capital requirement and its implications for your business.
Working capital is the lubricant that keeps your company’s finances running. In accounting terms, it is current liquid assets - such as cash, inventories and accounts receivable - minus current liabilities, such as accounts payable. Too little working capital can signal liquidity problems; too much working capital suggests you are not using your assets efficiently to increase revenues.
The question is: do you hoard cash and keep your working capital robust or run it low to take advantage of opportunities? Finding the right balance for this measure of assets to liabilities has become a moving target during the Covid-19 crisis. No matter how good your prospects are, your company will face bankruptcy if you can’t pay the bills; but you will shrivel up in the long term if you don’t invest.
Assessing and determining working capital requirements for your company can help you find that balance.
The Working Capital Requirement (WCR) is a financial metric showing the amount of financial resources needed to cover the costs of the production cycle, upcoming operational expenses and the repayments of debts. In other words, it shows you the amount of money needed to finance the gap between payments to suppliers and payments from customers.
The key components of the working capital requirement formula are accounts receivable (measured through the DSO, for Days Sales Outstanding), inventory (measured through the DIO, for Days Inventory Outstanding) and accounts payable (measured through the DPO, for Days Payable Outstanding).
Logically, the working capital requirement calculation can be done via the following formula:
WCR = Inventory + Accounts Receivable – Accounts Payable.
If you’re wondering how to assess your working capital requirement, look at its components first. A rise in WCR comes either from a higher number of accounts receivable, a higher inventory, or a lower number in accounts payable. And the reverse –that is, if the result of your working capital requirement calculation shows a drop – comes from either a lower DSO or DIO, a higher DPO, or a combination thereof.
A rise in WCR usually means companies are spending a lot of their financial resources just running the business and therefore haveless money to pursue other objectivessuch as new product development, geographical expansion, acquisitions, modernisation or debt reduction.The higher your working capital requirement, the more constraints you facein making forward-looking investments. So monitor any change in working capital requirement closely!
Another metric showing the ability of your company to pay for its current liabilities with its current assets is theworking capital ratio. However, instead of resulting in a hard number, as does the working capital requirement, the working capital ratio is a percentage, showing the relative proportion of your company’s current assets to its current liabilities.
A good working capital ratio is considered to be 1.5 to 2, and suggests a company is on solid financial ground in terms of liquidity. Less than one is taken as a negative working capital ratio, signalling potential future liquidity problems. An exception to this is when negative working capital arises in businesses that generate cash very quickly and can sell products to their customers before paying their suppliers.
As Philippe Vammale, Head of Risk Underwriting at Allianz Trade in France also warns: “Although the working capital is a key metric, more and more companies improve their working capital and infine their cash position by using financing structured as factoring and reverse factoring. Faced with these financial technicalities, the working capital analysis requires more attention and rigor as illustrated recently with the bankruptcy of the speciality finance firm Greensill Capital.”
What is affecting your working capital requirement?
The biggest drain affecting your working capital requirement is payment delays. Late payments can force many companies to draw on their working capital to pay the bills in the best of times, and in fact payment delays are the leading cause of insolvencies.
“Cash is king; cash flow is and will remain the sinews of war,” says Philippe. “25% of business failures are the result of suspension of payments. It is therefore essential that companiesmanage their cash flow rigorously.”
For example, monitor customer payments by requesting acknowledgement of invoices sent and follow up with reminders when payment terms have been breached. But be flexible before taking costly legal actions and maintain good customer relationships.
Determining working capital requirements to ensure future business growth
Over the past year, liquidity from government stimulus and tax supports injected much-needed cash into the economy and helped keep businesses afloat. Small business loans with attractive lending terms have allowed companies to benefit from the current low-interest-rate environment and upgrade, invest in projects, or make acquisitions that will ensure future profitability.
Before taking the investment step, bring in expert trade and risk analysis to help you find the balance between being too aggressive because of FOMO (fear of missing out) and being too conservative, with the risk of being overtaken by the competition. In addition, the recovery could be different from country to country. That’s something to keep in mind as you choose your investment targets. For example, an expert trade credit insurercan advise and help you make better-informed decisions.
Determining working capital requirements and understanding any changes will provide some margin for your company to manoeuvre and help you develop a forward-looking view and ensure future growth.
For more tips and advice on business monitoring, download our ebook: Boost your financial performance analysis.
