We’ve probably all been there: The business is fine; we’re paying our suppliers, paying our employees, paying our creditors, making a little profit, and then wham! A major client doesn’t pay his bill. Or an employee leaves a window open during a rainstorm, ruining $4,000 worth of inventory. Or you hear that your lease is up 25 percent, or your health insurance premiums now cost 50 percent more. And suddenly your business isn’t thriving. Temporarily you may not even be solvent.
Working capital (basically defined as your current assets minus your current liabilities) determines your ability to consistently meet short-term financial obligations and survive financial challenges. Technically, working capital includes assets that can be liquidated quickly if the need arises. But most small business owners don’t even think in terms of working capital but in terms of cash, notes Bill Collier, president of Collier Business Advisors, just outside St. Louis. When you don’t have enough working capital, or cash, if you prefer, you can’t meet financial obligations in a timely way. This can affect your credit rating, your relationships with other companies, your ability to grow the business, and, of course, your stress levels.
Collier walked me through some of the key calculations and considerations that will help a business know its own particular working capital needs.
Just how much working capital you need depends on a number of factors, including payroll, debt load, lease or mortgage, and the cost of inventory. But realize this: Businesses with high inventory turnover (think fast-food franchises or supermarkets) tend to need less working capital. When inventory sails out the door fast, cash flows into the coffers just as fast. And that provides the working capital a business needs. Conversely, businesses with low turnover (think large equipment manufacturers) or even seasonally low turnover (think specialized gift stores that see their greatest sales in December) need more working capital so that they can pay bills even when demand for services or products isn’t high.
In general, review your working capital needs weekly, Collier says, or at least monthly, so that you’re clear on what money is coming in and what money is going out. But you also need to a take a hard look at what you really need in the long term, cashwise, to keep solvent. That involves reviewing the patterns of your business’s revenue and expenditures, making sure you remember to track expenses that come up every couple of months (or even once a year), such as payroll taxes and insurance payments. Collier tells me that one big mistake he sees is failing to budget important payments. Once a backlog mounts, it’s difficult to catch up. Plus, you end up hit with fines and penalties.
While every business is different, first get a good sense of working capital by looking at your balance sheet, on which your working capital (current assets minus current liabilities) should be clear. In addition, Collier says there’s no substitute for doing a future cash flow forecast by projecting the next 12 months’ cash inflow (including loan proceeds) and outlays (including principal and interest payments).
How do you do this? Collier explains it: Set up a simple spreadsheet that starts with your beginning cash balance. Each month, add cash in and subtract cash out to come up with an ending cash balance. This in turn becomes the beginning cash balance for the next month, and so on.
Now, keep track of this amount for several months running and use it to forecast your cash needs in the next 12 months, being sure to take into account seasonal variations in sales, the amount of time customers take to pay, and so forth. This gives you a clear picture of how much money you need to have on hand to run your business smoothly.