The immediate health of a business is primarily determined by its net working capital. Working capital is nothing but the assets that can be used to pay off short-term expenses. This includes w cash, inventory, accounts receivables etc.
Any businessman must, at the outset, determine the working capital finance needs of the business. It is after all, the backbone on which day-to-day business operations run. If you are not able to pay your staff salaries, or buy or rent equipment, your business is bound to fail. Startups in the initial stages may not generate revenue and hence may not have a working capital inflow; it is then advisable to borrow money from an appropriate source to keep operations going. Another reason to forecast working capital finance needs accurately is that investors often evaluate a startup by its working capital ratio, a key indicator of its financial success. This can make or break a major investment. It thus becomes extremely important to correctly factor in the amount of working capital needed till the time you break even. One hears of many cases where taking the wrong amount of working capital loan has brought several challenges upon the company.
Here is what to look at to determine your business’ working capital needs as accurately as possible:
1. The Operating Cycle: Examine the operating cycle of your business in terms of number of days by applying the following formula:
Net working capital requirement = Inventory + Accounts receivable – Accounts payable
Accounts receivable is the average number of days taken to collect an account. Inventory means the average number of days taken for turning over a product sale. Accounts payable is the average number of days taken to pay a supplier.
2. Industry of operation: While carrying out the above assessment, it is important to know and apply the industry norms for the industry you operate in, an important factor being the industry credit policy. For example, a trading concern has a higher need to maintain large inventories, receivables and cash and hence its working capital finance requirement will be higher. On the other hand, a services firm allows only short-term credit and thus requires lower working capital finance. Manufacturing will lie somewhere in between these two. The industry you belong to has a strong impact on your operational and strategic philosophies. For example, a fast-paced paced and competitive industry demands quick customer responsiveness, making it mandatory to maintain a high level of inventory. As a norm, the more liberal the credit terms, the more pressing is the mandate to deliver extremely quick and high-quality service. As a result, higher the competition, the greater is the
working capital finance requirement.
3. Scale of operations: As a general rule, the larger the scale of operations, the more is the working capital finance requirement. However, this may differ from business to business and it is best to assess your scale and scope of operations for working capital loan assessment. For example, if you have high overheads or use resources inefficiently, your working capital finance requirement is bound to increase.
4. Stage in business life cycle: Generally, in the initial stages of establishment, larger amount of working capital finance is needed, since the company is heavy on investment and in establishing credibility. As you grow, returns will hopefully be realised, and dependence on external financing will reduce as you pump in your profits to further your business. Assess the stage at which your business is to determine your working capital finance needs accurately.
5. Production policy: If you are a manufacturing business, it is very important to establish a suitable production policy. If production is done on the basis of orders, less working capital finance will be needed. If you carry out production by anticipating future demand, high uncertainty prevails and you may need to go for higher working capital loans to offset the cost of non-sales. If your product is seasonal in nature, generally higher working capital finance is the norm.
6. Working capital cycle: Perhaps the single most direct factor that determines the extent of working capital finance required is the nature of working capital cycle. This is nothing but the time required to convert the raw materials into finished goods and further into cash receipts. Sticking to a longer cycle may find you
opting for higher working capital loan amounts.
Some of the other areas to look at for financing of working capital are taxation rules, raw material availability, business cycle basis macroeconomic factors, speed of growth, rate of stock turnover, dividend policies, pricing changes, sales volumes, operating efficiency, profit appropriation and so on.
A careful assessment of all factors must be carried out, not only for the present but also keeping in mind the near future. Make sure you assess and reassess your working capital finance status in line with the overall business strategy i.e., in conjunction with your overall business assessment such as profits, retained earnings, overheads and one-time expenses, growth plans and so on. A holistic assessment will help you arrive at a realistic picture and then you can approach a lending institution with confidence to secure the much needed financing of working capital.
The next step is to choose the right source of
working capital finance to give your business the financial boost that it needs. A number of options for short-term working capital are available such as equity, trade credits, factoring, line of credit or a short-term loan from a bank. The initial stages may require reliance on more than one source. However, as you progress and make profits, it is a good idea to redirect the retained earnings into the financing of working capital to reduce external dependencies.