How to Determine Your Working Capital Needs

Working capital is one of the most difficult financial concepts for the small-business owner to understand. In fact, the term means a lot of different things to a lot of different people. By definition, working capital is the amount by which current assets exceed current liabilities. However, if you simply run this calculation each period to try to analyze working capital, you won't accomplish much in figuring out what your working capital needs are and how to meet them. A more useful tool for determining your working capital needs is the operating cycle. The operating cycle analyzes the accounts receivable, inventory and accounts payable cycles in terms of days. In other words, accounts receivable are analyzed by the average number of days it takes to collect an account. Inventory is analyzed by the average 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 converted to cash or an account receivable). Accounts payable are analyzed by the average number of days it takes to pay a supplier invoice. Most businesses cannot finance the operating cycle (accounts receivable days + inventory days) with accounts payable financing alone. Consequently, working capital financing is needed. This shortfall is typically covered by the net profits generated internally or by externally borrowed funds or by a combination of the two. Most businesses need short-term working capital at some point in their operations. For instance, retailers must find working capital to fund seasonal inventory buildup between September and November for Christmas sales. But even a business that is not seasonal occasionally experiences peak months when orders are unusually high. This creates a need for working capital to fund the resulting inventory and accounts receivable buildup. ome small businesses have enough cash reserves to fund seasonal working capital needs. However, this is very rare for a new business. If your new venture experiences a need for short-term working capital during its first few years of operation, you will have several potential sources of funding. The important thing is to plan ahead. If you get caught off guard, you might miss out on the one big order that could put your business over the hump. Here are the five most common sources of short-term working capital financing: 1. Equity. If your business is in its first year of operation and has not yet become profitable, then you might have to rely on equity funds for short-term working capital needs. These funds might be injected from your own personal resources or from a family member, a friend or a third-party investor. 2. Trade creditors. If you have a particularly good relationship established with your trade creditors, you might be able to solicit their help in providing short-term working capital. If you have paid on time in the past, a trade creditor may be willing to extend terms to enable you to meet a big order. For instance, if you receive a big order that you can fulfill, ship out and collect in 60 days, you could obtain 60-day terms from your supplier if 30-day terms are normally given. The trade creditor will want proof of the order and may want to file a lien on it as security, but if it enables you to proceed, that should not be a problem. 3. Factoring. Factoring is another resource for short-term working capital financing. Once you have filled an order, a factoring company buys your account receivable and then handles the collection. This type of financing is more expensive than conventional bank financing but is

often used by new businesses. 4. Line of credit. Lines of credit are not often given by banks to new businesses. However, if your new business is well-capitalized by equity and you have good collateral, your business might qualify for one. A line of credit allows you to borrow funds for short-term needs when they arise. The funds are repaid once you collect the accounts receivable that resulted from the short-term sales peak. Lines of credit typically are made for one year at a time and are expected to be paid off for 30 to 60 consecutive days sometime during the year to ensure that the funds are used for short-term needs only. 5. Short-term loan. While your new business may not qualify for a line of credit from a bank, you might have success in obtaining a one-time short-term loan (less than a year) to finance your temporary working capital needs. If you have established a good banking relationship with a banker, he or she might be willing to provide a short-term note for one order or for a seasonal inventory and/or accounts receivable buildup. In addition to analyzing the average number of days it takes to make a product (inventory days) and collect on an account (accounts receivable days) vs. the number of days financed by accounts payable, the operating cycle analysis provides one other important analysis. You can see that 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, a good understanding of working capital is imperative to making any venture successful.

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What is Net Working Capital?

Net Working Capital (which is also known as Working Capital or the initials NWC) is a measurement of the operating liquidity available for a company to use in developing and growing its business. The working capital can be calculated very simply by subtracting a companys total current liabilities from its total current assets. Through this formula, a working capital amount can be determined to be either positive or negative. Naturally, this will rely largely on the amount of debt owed by the company. It should not come as a surprise that having plenty of working capital tends to help companies achieve more success. This follows because working capital allows companies to grow smoothly and make necessary improvements to their corporate operations. On the other hand, companies that are operating with negative working capital may not have the financial support or flexibility to grow and/or improve, even when such developments would be indicated. Hence, working capital can be an indicator of the overall strength of a company.

There are three main indicators used in calculating working capital. Elements of the current assets side of the equation will include accounts receivable, as well as any inventory of goods on-hand. Current liabilities will include accounts payable. A positive change in a companys working capital will generally indicate one of two developments. Either the company has increased its current assets by receiving cash (or some other form of assets), or it has minimized its liabilities often by paying off a short-term creditor.

Capital Expenditure
Capital expenditure occurs when a business gets a long term advantage due to that expenditure. It is usually incurred for accusation of an asset. These expenditures do not occur in the regular day to day transactions of the business. Common examples Purchase of furniture, office building etc. Purchase of additional furniture or machinery Expenditure incurred in connection with the purchase of a fixed asset. For example, carriage paid of machinery purchased. Purchase of patent right, copy rights etc.

Revenue Expenditure
Expenditure which is not for increasing the value of fixed assets, but for running the business on a day to day basis, is known as revenue expenditure.

Difference between Capital and Revenue expenditure

Buy a car is capital expenditure because its benefit to the business will be spread over a long time. Fuel cost for running this care is revenue expenditure and it will be used up in few days and does not add to the value of the fixed asset.

Capital receipts
Capital receipts consist of additional payments made to the business either by owner or shareholder of the business; or from sale of fixed assets of the business.

Revenue receipts
Any receipt in the normal running or through day to day transactions of the business is categorized as Revenue receipt. Sales receipts of the business are revenue receipts.

Net working capital is one of the classic measures of a company's liquidity. Net working capital is a pure balance sheet measure, as such it can be calculated at any time without worrying about annualizing the calculation as is necessary when calculating ratios that use both the income statement and balance sheet together such asaccounts receivable turnover.
The formula for net working capital is: Net working capital = current assets - current liabilities Many lending institutions and financing facilities like to use working capital as one of the covenants that need to be maintained. Example: Google Inc Fiscal periods ended Current assets Current liabilities Net working capital 12/31/05 12/31/06 9/30/07 <--------In Millions of Dollars-------> $9,001 745 $8,256 $13,039 1,304 $11,735 $15,734 1,783 $13,951

As can be seen, Google continued to add to their net working capital over the period analyzed. The components of net working capital are also used to calculate the current ratio.