7 Factors to Consider When Determining Your Company’s Working Capital Needs

22 Jan, 2016 / Comments: Comments Off on 7 Factors to Consider When Determining Your Company’s Working Capital Needs / By

Working capital is one of the trickiest financial concepts for a business owner to get a handle on. The truth is the term can mean a lot of different things to different people. However, the definition of ‘working capital’ is the amount that assets exceed liabilities. Let’s take a look at seven factors to consider when determining your small business’s working capital needs.

 

Business Cycle

Your need for working capital is impacted by different stages of your business cycle. During its boom period, the product demand will be substantially increased and so your sales will also be increased. This means that you will need to have more working capital. On the other hand, when your business is going through a depression, demand decreases which has an impact on both sales of goods and production. This means that you do not need as much working capital.

 

Type of Business

Your working capital needs depend on the kind of business you have. Typically, a business will fall into two categories—trading business and manufacturing business. If you have a manufacturing business, then it takes time to convert raw materials into the finished product. Due to this, a lot of capital will remain invested in the raw material, semi-finished products, and then the stocking of the finished good and so you must have more working capital than if you are a trading business. On the other hand, as a trading business, you typically sell goods right away after you purchase them or in some cases the sale may be affected even before the purchase is made. As a result, you do not need to have a lot of working capital.

 

Seasonal Factors

Some goods have a high demand throughout the year while others only have a seasonal demand. Goods that have the same demand for the whole year means that their sales and production remain constant. Due to this, businesses with constant demand do not require a lot of capital. Conversely, some companies have a seasonal demand but are still producing throughout the year so that they have enough supply to meet demand. These types of companies have to have a large stock of finished products and raw material on hand, at all times, and so they require much greater working capital amount.

 

Equity

If your business is just starting out and has not yet gotten to the stage where it becomes profitable, then you may need to rely on equity funds to meet your short-term working capital requirements. You can get these equity funds either by tapping into your own personal equity source or by asking a friend, family member, or third-party investor.

 

Operating Efficiency

Your Operating Efficiency is how efficient your business is at finishing different business operations. Every organization has a different operating efficiency. For instance, one company may be better at finishing goods early while another may be good at selling the finished products while another can quickly collect payments. Those businesses that have a high operating efficiency overall do not need to invest as much into the debtors and stock, and so those companies with high operating efficiency do not need as much working capital. On the other hand, those that have less of an operating efficiency need more.

 

Raw Material Availability

Raw material availability also has an impact on how much working capital you need. If your business uses raw materials that are easily available year-round, then it will need less working capital as there won’t be a need to keep a large stock. On the other hand, if your business uses raw material that only becomes available at certain times of the year, but you need to keep your production constant; then you must have large stocks of your product at all time to keep up with demand. In this case, you will need to have more working capital on hand.

 

Credit Available and Credit Allowed

If your business sells goods or services only on a cash payment basis, then you do not need as much working capital as those who make a credit facility available to their customers. Those types of companies that allow credit require much more working capital. Additionally, if your raw material, as well as other inputs, is made easily available through credit, then you will not need as much working capital. On the other hand, if a lot of the raw material you use cannot be purchased using credit then you are going to have to have to make significant cash payments, which means you need more working capital.

William Mahnic
William Mahnic is a Finance Professor at Case Western University and has spent more than 20 years in the finance industry before becoming a professor. Mahnic has appeared as a commentator on both TV and radio talk shows including NPR, Crain's Cleveland Business, WKYC 3 and The Washington Post. He has been interviewed in BusinessWeek, Wall Street Journal and The Los Angeles Times.

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