Last Updated on October 12, 2023
As a business owner, properly managing your working capital is essential to maintaining healthy business operations and creating growth opportunities, and knowing how much working capital you need is the first step towards achieving this type of financial health.
However, understanding the amount of working capital you need can be tough since there are many factors that influence this. For example, the size of your business, industry, and seasonality can all impact how much working capital you should have.
In this article, we will help you better understand how much cash you should have on hand to maintain daily business operations and help you become a more financially savvy business owner.
What Is Working Capital?
Working capital (also called “net working capital“) is the difference between a company’s current assets and current liabilities. Put more plainly, working capital is the cash that a business uses to maintain its day-to-day operations.
Working capital is used as a liquidity and efficiency metric and is a vital measure of a company’s overall financial health. Because each business needs varying amounts of capital to manage daily operations, the amount of working capital you need depends on many factors.
How to Calculate Working Capital
Working capital is calculated by subtracting a company’s current liabilities from its current assets, as seen below.
Working Capital = Current Assets – Current Liabilities
Examples of current assets can include:
- Cash equivalents
- Accounts receivable
- Prepaid expenses
Examples of current liabilities can include:
- Short-term debt
- Accounts payable
- Payroll taxes
- Notes payable
How Much Working Capital Should a Business Have?
Determining how much working capital a business needs can be a difficult task because there are so many different factors that need to be taken into consideration. At the end of the day, there is no one-size-fits-all solution to how much working capital a business should have, but as a general rule of thumb, you should have more capital available than needed to cover your existing expenses.
Using the Current Ratio to Determine How Much Working Capital You Need
The current ratio, also known as the working capital ratio, is an excellent tool to help you determine how much working capital you should have. To calculate the current ratio, you will need to divide your current assets by your current liabilities, as seen below.
Current Ratio = Current Assets / Current Liabilities
A positive current ratio means that you have enough current assets available to cover your short-term debts. While the definition of a good current ratio can vary, generally speaking, between 1.5 and 2.0 is a good ratio to aim for. A current ratio between 1.5 and 2.0 typically shows that you have enough working capital available while using your assets efficiently.
Working Capital Requirement Factors
While we have provided some general rules of thumb above to guide you in deciding how much working capital your business should have, below are some additional factors to consider that may impact how much cash you should have available.
The industry you operate in can influence how much working capital you need. For example, businesses that require more inventory or raw materials typically need more working capital than service-based businesses because working capital is necessary to make frequent inventory purchases.
Industries that may require more cash include manufacturing, wholesale, and retail, while those that may require less include consulting, serviced-based businesses, and retailers that sell intangible products (such as software or insurance providers).
Similar to industry, business size can influence how much working capital you should have on-hand. A smaller company will likely need less money than a large company because its business operations are on a more smaller scale.
Business seasonality is an important factor in determining how much cash you need throughout the year. Depending on the type of business you operate, you may have peak seasons and slow seasons, meaning your working capital requirements will be influenced based on the time of year. For example, if you operate a retail shoe business, you will likely need more working capital during the winter holidays to purchase inventory and fulfill orders during peak shopping months.
Every business has a different operating cycle (also known as a “production cycle”), and the characteristics of the operating cycle can impact working capital requirements. Longer-operating cycles often call for greater working capital needs since money can get tied up in the production process.
Additionally, a company’s invoicing process and payment terms can influence the length of the operating cycle and, therefore, impact the amount of working capital needed. This is why it is often ideal to have a shorter production process and seek payment from customers quickly.
Any business goes through its own company lifecycle, and the stage it is at can impact how much working capital it needs. For example, a startup likely needs much less capital than an enterprise-level company.
Similarly, outside factors can influence the stage that a business is at in its lifecycle and its capital requirements. For instance, a recession can negatively affect cash flow, shifting business goals from growth-oriented to maintenance mode, lowering its working capital needs.
Jim Pendergast, General Manager at altLINE, shares his perspective, saying, “The company’s industry plays a big role in the business’s cash flow needs, but perhaps more importantly, the business owner must consider where the company is in its lifecycle to determine working capital needs. Is the company’s revenue growing, stable, or declining? What sort of off-balance sheet capital sources can the company call on in a pinch? Asking yourself these sorts of questions can help you better understand how much working capital you truly need.”
How to Improve Working Capital
If you’ve read this far and have learned that you are in need of additional working capital, don’t worry! Below are some ways to increase working capital for your business:
- Send invoices sooner: A client cannot pay an invoice that they do not have. Sending invoices to your clients sooner kickstarts the countdown to the invoice due date, meaning you are more likely to get access to working capital in a timely manner.
- Pay your invoices later: Waiting later to pay your invoices keeps more working capital in your business, giving you the opportunity to make higher priority payments sooner. Just be sure you still make on time invoice payments to maintain positive working relationships with your vendors and suppliers.
- Use invoice factoring: Invoice factoring can improve your working capital and inject cash into your business by selling your unpaid invoices to a third party factoring company. This alternative financing method is particularly helpful for small and medium sized businesses that do not qualify for traditional lending options, like a line of credit or business loan.
- Follow up on unpaid invoices: According to Chaser, only 12.9% of invoices get paid before the invoice due date, but businesses that follow up on 90% or more of their unpaid invoices get paid within a week of the due date. Following up on invoices can increase their likelihood of getting paid sooner, helping you access cash more quickly.
Give altLINE a Call
With an A+ rating from the Better Business Bureau, altLINE is dedicated to providing quality customer service and invoice factoring to small and medium sized businesses across the United States. If you need to improve your cash flow or have been denied financing from another lender, give altLINE a call at +1 (205) 607-0811 or fill out our online factoring quote form. We would be happy to assist you in reaching your business goals!
Angela is the Director of Online Marketing at altLINE where she manages content production, marketing and sales operations, and digital PR. Angela joined altLINE in 2022 after several years of working in digital marketing across various industries including financial services and B2B. Angela loves creating content that helps readers better understand their financing options and helps them make informed decisions about factoring. Her work has been featured in publications like Search Engine Journal and Moz.