The working capital of an enterprise can be calculated by applying a simple formula: working capital = current assets – current liabilities. Current assets includes short-term assets that can be converted into cash within a year, whereas current liabilities refer to the short-term liabilities which are due payment within a year. An enterprise’s working capital can be either positive or negative. But the working capital needs differ from one enterprise to another. The working capital requirements even differ from one industry to another. There are a number of factors that influence the working capital needs of a business directly.
Important Factors to Consider while Determining Working Capital Needs of a Business
The seasonal businesses need additional working capital during a specific season. For instance, the winter garment manufacturers need more working capital during winter season, whereas the businesses manufacturing air-conditioners needs additional capital in summer. While determining working capital needs of a seasonal businesses one must consider the peak demand period.
Each business need some time to convert raw materials into finished goods. The amount of time required to produce finished goods will influence the business’s working capital need. If the production cycles are short, the enterprise will not need additional working capital. But the business will need additional working capital if the production cycles are long.
Raw Material Supply
The price of raw materials keep fluctuating from time to time. Also, certain raw materials cannot be procured easily through the year. Hence, often businesses need additional working capital to store raw materials for extended periods. The additional working capital further helps businesses to procure raw materials at lower prices. Business owners can opt for short term unsecured business loans to get additional working capital to grow the business.
Like production cycles, operating cycles also influence a business’s working capital needs. Operating cycle refers to the time required to convert short-term assets like inventory and account receivables into cash. Also, it consider the due date of accounts payable. The operating cycle is calculated in terms of days. A business will need additional working capital if the operating cycles are longer.
Expansion and Growth
Often businesses have to modernize their processes and operations to beat competition. The businesses will need additional working capital to fund modernization, expansion, or growth. The additional working capital will further help the businesses to survive in competitive industries.
The government policy and inflation often escalate the cost of raw materials and labour rates. No business can continue production without investing funds in inventory and retaining skilled labourers. Hence, the need additional working capital to cover the escalated price level.
Cash Flow Position
The cash flow position of a business influences its immediate working capital needs. If the cash flow is positive, the business can easily fund its business operations without requiring extra working capital. On the other hand, the business has to explore working capital financing options to improve cash flow position. Here are some tips to manage business cash flow.
Often enterprises have to pay tax in advance to meet government regulations. They also need to pay taxes on time to avoid penalties and extra fees. The businesses will need additional working capital to pay taxes in advance or time. The enterprises block a part of working capital to pay taxes on time.
An enterprise can meet working capital needs through both internal and external funding sources. Many entrepreneurs prefer meeting working capital needs by retaining a part of annual profits. When an enterprise retains earnings or profits, it can easily meet financial obligations without requiring additional working capital.
On the whole, the working capital requirements of a business is influenced by a number of factors. One can never determine an enterprise’s working capital needs without considering these factors. Also, it is important to forecast the working capital requirements of a business as a percentage of revenue.