Working capital: What is it, and how much does your business need?

For example: If your overheads are $100,000 a month, and you always want three months in advance, your working capital requirement is $300,000.

The essential point about working capital is that it’s the cash required for the day-to-day running of operations.

Generally, the longer the business cycle, the more working capital you require. A business cycle is the time taken for a product to be made (or bought), then on-sold, and money received and cleared at the financial institution.

Determine your working capital needs

One of the first things to do is decide how much working capital you need.

Use a cash flow forecast to calculate when you might run out of cash and what base level of capital will help prevent that from occurring.

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Manage your working capital

The more you can cut expenses, the better.

Consider these tips to manage your working capital effectively:

• Reduce large personal withdrawals. If you have spare cash, make sure your business doesn’t need it first.
• Don’t buy major assets out of day-to-day operating profits if it places stress on your capital. It’s best to set money aside—or use other financing options like leases or loans—to spread these costs over several years.
• Avoid overtrading. It can sound good when one or more of your customers suddenly increases their regular order. But if you must add on more overheads and the customer takes longer to pay, you can have real cash stress.
• Reduce your inventory costs. Make sure you order effectively, getting just what you need. It can be tempting to order in bulk and receive a volume discount. But it eats into your cash.
• Make it easy for customers to pay you. Consider updating your payment options so that customers can pay you faster, keeping more cash in your business.

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Shorten your cash cycles

You might be able to shorten your cash cycles with one of these strategies:

• Collect money fast. And make sure you have systems to effectively deal with people who owe you money, especially before you agree to extend credit.
• Talk to your suppliers about improving their terms. It might seem like a good idea to pay your bills fast. But if it’s quicker than your customers pay you, you need more working capital.

Conduct cash flow and profit-and-loss forecasts

If you can produce accurate cash flow forecasts, you’re in a better position to see what’s happening to your working capital—and take steps to improve it before you’re forced to.

You’ll predict when you need short-term financing to bridge gaps and when you’re likely to have an increased revenue stream to invest.

Profit and loss forecasts help you assess the future profitability of your business so that you can make better, clearer decisions about your needs.

Final thought

Ideally, you want to reduce any working capital jitters you might have by fully understanding what it is, how much your business needs and how you can continually improve it.

Consult with your accountant about your working capital needs, how you can reduce them and what you can do to improve them.

Once you’ve learned how to manage it effectively, it’ll become second nature to you. Then, you can focus on growing your business and increasing profitability.