Calculating Your Working Capital Needs

Having enough working capital is essential for many small businesses. Working capital ensures that you have enough cash on hand to fund day-to-day operations and keep your business running.

But knowing how much working capital your business needs can be complicated.

So how do small business owners calculate how much working capital they need? Let’s explore how you can calculate your working capital needs, why it matters and a few ways you can increase it.

How Much Working Capital Do I Need for My Small Business?

Small business owners generally strive for a working capital ratio between 1.5 and 2. This means you have enough working capital to cover your liabilities with some left over to make critical investments. At the very least, it’s prudent to ensure that your working capital is positive — that you have enough cash on hand to cover liabilities.

The exact amount of working capital your business needs, however, depends on the type of business you run, the size of your operations and many other factors. For example, if your business has to restock inventory often or needs a lot of raw materials, you may have higher working capital requirements than other businesses.

How Do You Figure Out Your Required Working Capital?

There are two formulas you can use to figure out how much working capital your business requires. The working capital ratio formula and the working capital formula. Both of these require you to create a list of your current assets and current liabilities. Current assets include things like cash or cash equivalents, inventory and accounts receivable. While current liabilities include accounts payable, wages, taxes and short-term business loans.

Working capital ratio formula

Your working capital ratio can give you better insight to whether or not you have enough working capital. It’s a metric used to measure your company’s liquidity and financial health. To calculate it, simply divide your current assets by your current liabilities. Typically, a good working capital ratio is between 1.5 and 2.

Working Capital Ratio = Current Assets / Current Liabilities

Working capital formula

The working capital formula (also known as the “net working capital formula”) can help you determine if you have positive working capital. The formula is fairly simple. You simply subtract your current liabilities from your current assets.

Working Capital = Current Assets – Current Liabilities

If this number is positive, it means you have positive working capital and can cover your current business operations. If this number is negative, you have negative working capital and you may need to find a way to either increase revenue or decrease expenses.

What Are Some Factors I Should Consider When Estimating My Working Capital Needs?

Cash flow cycles. Your cash flow cycle can have a big impact on your working capital requirements. This cycle measures how long it takes your business to convert inventory into cash. If you have a longer cash flow cycle, you may need to keep more working capital on hand to cover business expenses while waiting for customers to pay.

Short-term financial obligations. Short-term financial obligations include the things listed in your accounts payable, such as short-term debt and payroll. These current liabilities may need to be covered and can help establish a baseline of how much working capital you need to keep your business running.

Plans for growth. If you have plans to grow your business, consider factoring that into your working capital needs as well. During times of growth you may run into more expenses like taking on a new business loan. Plus, you may also be reinvesting revenue into expanding as well. It may be important to plan ahead so you can remain liquid enough to cover your day-to-day expenses while also funding growth.

Seasonality. If you have a seasonal business, you’ll likely have different working capital requirements during the busy season than you do during the slow season. You may need to hire seasonal staff or purchase more inventory when it’s busy, but you’ll also need to plan for the decrease in sales when it’s not.

Why Is Having Enough Working Capital Important?

Having enough working capital helps ensure that your business is prepared for anything. Whether it’s an unexpected expense or a surprise growth opportunity, having enough working capital helps your company to navigate through these scenarios easier. It acts as a financial cushion, helping to maintain stability but also enabling you to adapt to changing circumstances.

How Can I Increase My Working Capital?

To increase your company’s working capital you either need to boost the amount of money you’re bringing in or decrease the amount of money you’re spending. Here are a few things to consider.

Manage your inventory efficiently. Use inventory management techniques to avoid purchasing too much inventory.

Refinance your short-term debt. Lenders may allow you to refinance your short-term debt. This can lower your payments and your short-term liabilities. Keep in mind that you may be paying more in interest over time, and you may need to factor in other terms and fees.

Negotiate with vendors. Talk to your vendors to see if they can offer you a better deal on supplies.

Consider a working capital loan. A working capital loan or line of credit can provide you with the extra cash you need. However, before borrowing it’s often best to explore other options to avoid unproductive debt.