Small Business Taxes & Management

Special Report

Working Capital--It's Not Just a Term


Small Business Taxes & ManagementTM--Copyright 2014, A/N Group, Inc.




If cash is king, working capital is the queen.

The fundamental accounting equation is "assets = liabilities + net worth". As long as your assets exceed your liabilities, your business is technically solvent. But more than one solvent business has failed because it couldn't pay its current debts. And consider your assets. Even if your assets exceed your liabilities by a significant margin, would you sell or borrow on your trucks or equipment to raise cash?

You can't pay your bills if you don't have cash. And you can't take advantage of opportunities. For example, the contractor in the next town over is going out of business and selling a some power tools cheap. He's already got two cash offers and isn't going to wait till you get some cash together.

But cash doesn't provide much of a return, particularly in the current environment. Most investments that can be converted instantly into cash such as a money market fund, bank deposit, won't pay much more than 1%.


Working Capital

First, while the term working capital is ubiquitous in business discussions, most business owners can't define it. Gross working capital is equal to a firm's current assets. But more important is net working capital (NWC) and that's equal to current assets less current liabilities. By definition, current means within an accounting cycle, usually one year.

Current assets include:

Current liabilities include:

Some additional definitions are in order. Prepaid expenses are expenses paid in advance such as the premium on a business insurance policy paid for in advance. Accrued expenses are expenses that have been incurred but not paid such as pay that's earned by employees at the end of the year but not paid until the following year, utility charges for which you haven't been billed, etc. They differ from accounts payable in that you haven't received a bill.

The best example of unearned income is the sale of a 1-year magazine subscription. You receive the money up front so you have cash in the bank, but you have to fulfill the subscription over the remaining 1-year period. Long term debt frequently has a current portion--that's the amount due within the next 12 months. It's a current liability and must be included here.


How it Works

The idea is that your current assets will be converted to cash during the next 12 months and your current liabilities will have to be paid within that same time period. In fact, your receivables are likely to turn into cash much quicker, and may do so a number of times during the next year. The same is true of your current liabilities.

If your net working capital (NWC) is positive (e.g., current assets less current liabilities is a positive number) the theory is you have enough working capital to fund your current operations. If your working capital is negative you need to get some financing if you expect to continue in business. Unfortunately, neither statement is completely true. However, negative working capital should be a cause for concern. Your working capital may be artificially low because you just bought a new truck with available cash. Or it could be high because you just took down financing to begin construction on a new building.

You may be able to start with your working capital amount and make any important adjustments, but outsiders such as a bank or other potential lender is unlikely to adjust the number.

Of potentially more importance is the working capital cycle. That's the time it takes from when you lay out cash to when you collect from customers. For example, you pay your employees at the end of every week, but can't collect from customers for that work for 30 days. You need to fund 23 days of working capital--more if you can only bill the customer at the end of two or more weeks of work. Some businesses have much longer working capital cycles. Manufacturers must pay for raw materials, but it could take some time (and additional expense) before those items are changed into finished goods ready for sale. On the other hand, certain businesses can bill customers in advance. For example, you require a 50% deposit before beginning work. Small businesses are often at a disadvantage, getting less than the best terms when purchasing while finding payments to them stretched out selling to larger companies.

Unfortunately, for most businesses there's no way to really ascertain the full impact of the working capital cycle. There's just too many variables. The best you can do is look at the most important factors--generally that's inventory, receivables, and trade payables.

What you want to do is reduce the time it takes to collect receivables and translate inventory into receivables and delay paying liabilities as long as you can. But there are a number of other tricks.



Despite the ads you see from banks, working capital management is more than getting faster credit for your deposits.

Cash budget. Analyze your cash flow and set up a cash budget. A cash budget will allow you to see when the cash is coming in--and going out. It's critical if you have an uneven cash flow such as a seasonal business, large variations because of loan repayments, etc. But even a business with even cash flow needs to plan for equipment purchases, etc.

Correct financing. Try to match the asset term to the financing. For example, don't use cash or short-term loans for long-term assets such as vehicles and equipment. You can finance them with loans, often from the dealer. That allows you to retain cash for receivables and inventory which can be difficult and/or expensive to finance.

Lender requirements. Lenders like to see that you can manage your working capital. In fact, some lenders have covenants in their loans with working capital requirements. While loans are available for working capital, they're often based on seasonal requirements or for expansion.

Growth companies. If your business is growing, forecasting working capital is more important. You'll need money to finance receivables, inventory, etc. which are increasing with increased revenue. The faster you're growing, the more important the analysis and a cash budget becomes.

Shrinking inventory. Keeping inventory to a minimum is one way to increase working capital, but there's an offsetting cost, often called shortage. If you don't have inventory on hand to fulfill the sale you might lose the sale, or even the customer. In some cases the costs can be much higher, such as the shutdown of a manufacturing operation. Using the economic order quantity formula (EOQ) can give you a better idea of what you need.

Other factors. Every company is unique. Two identical businesses can have very different requirements. Take two local paint distributors. Madison's customer base is 50% professional painters and contractors and 50% retail. Chatham's is about 50% retail customers and 50% local governments. While both can feel the impact of a promotion by a big box retailer, Chatham is also at the mercy of local governments. A couple of lost bids, some deferred jobs, can have a serious impact. There are a myriad of other factors such as the financial resources of the partners or owners, the debt-to-equity ratio of the business, etc.


Other Resources

For other points on managing cash flow, speeding up collects, how to develop a cash budget, etc. see our articles Cash Flow Budget-Part I and II.


Copyright 2014 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536

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--Last Update 08/19/14