As the saying goes, cash is king. This is especially the case in times of crisis and uncertainty. The coronavirus pandemic and associated lockdowns are classic examples of this, and have provided companies in all areas of industry with a unique set of challenges.
With the furlough scheme coming to an end, understanding how to assess working capital requirements is essential to giving your firm the best possible chance of emerging unscathed.
What is Working Capital?
Before we explore how to assess working capital requirements, we will first of all explain what the term actually means. Put simply, it is the difference between a company’s current assets and current liabilities.
Working capital measures whether a business has enough liquid assets to cover its bills for the next twelve months. If the firm has a surplus of capital, not only can it easily fund its day-to-day operations, but it can also invest in growth without needing to take on additional debt.
A business that has a ratio of more than 1 will be capable of converting assets into cash at a faster rate, meaning it is much more capable of honouring its short-term obligations and dealing with unexpected occurrences. Having a ratio of less than 1 suggests the firm may not be able to cover its debts, making it a risk for investors and creditors alike.
Factors Affecting Working Capital Requirements
The main factors affecting working capital requirements are the firm’s current assets and current liabilities. Examples of current assets include:
- Cash in the bank
- Property
- Inventory
- Accounts receivables
Meanwhile, examples of current liabilities are:
- Accounts payable
- Leases
- Taxes
- Staff wages
There are additional elements at play too, which can have varying effects depending on the type of business you operate and the market you are in. For example, a manufacturer will have to buy and hold inventory of raw materials. They will also incur production costs to craft their products before selling. Retailers, on the other hand may simply be able to purchase stock from their suppliers and sell them straight on to consumers.
Other factors affecting working capital requirements include:
- Seasonality of operations
- Conditions of supply
- Production policy
- Level of competition
- Credit terms
Methods of Estimating Working Capital Requirements
The most basic way of calculating the working capital requirements of a business is using the current ratio. It is estimated by dividing the firm’s current assets by its current liabilities. Let us say that a company’s assets are worth £40,000 and it has liabilities of £20,500. This means its working capital ratio would be 1.95.
Another simple method to calculate working capital requirement is to exclude cash from the mix. To demonstrate this formula, we will take the example above and assume that £15,000 of the company’s assets is in cash. Its working capital requirement would therefore be 1.22. The final basic method involves utilising only the “core” accounts that make up working capital in the day-to-day operations of the business. It is calculated as follows:
Accounts Receivable + Inventory – Accounts Payable
Let us assume that a firm’s account receivable is worth £30,000, its inventory is worth a further £15,000, and its accounts payable is worth £10,000. This would mean its working capital requirement would be £35,000.
While the above formulae are the most standard examples of how to assess working capital requirements, there are other, more focused methods.
Percentage of Sales Method
This way of working out working capital requirements is based on the principle of ‘history repeating itself’. It involves working out the relationship between sales and working capital over an extended period of time, for example five years.
For example, if the working capital requirement is usually around 25% of sales, the following years’ estimate will follow this formula. This means that if the firm is predicting sales to be £100,000, its working capital will be £20,000.
The advantages of this method is that it is incredibly simple to understand and calculate. However, the fact that it works off assumption alone makes it difficult for many companies. This is especially the case for firms where there is absolutely no correlation between revenue and working capital. Because it relies on past behaviour, it is also not suitable for startup firms as there is no previous data to refer to.
Operating Cycle Method
Probably the most reliable way to assess working capital requirement, this method actually takes into account a company’s industry or business situation. It involves a general rule: the longer the working capital cycle is, the higher its working capital requirement would be — and vice versa. The formula is as follows:
Working Capital = Estimated cost of goods sold x (number of days in operating cycle /365 days) + Bank and cash balance
Let us assume that the costs of goods sold for a business are £20,000, its operating cycle is 45 days and the bank balance required is £100,000. The working capital requirement in this scenario would be £102,466.
Why You Should Work With Inquesta
If you are unsure about how to assess working capital requirements, you can rely on Inquesta to help. We are specialists when it comes to all forms of business finance, forensic accounting and corporate insolvency.
We are also experts in business recovery and restructuring, meaning we are perfectly placed to assist if you feel any uncertainty surrounding how your company will cope with coming out of the furlough scheme. This is why we have put together a free eBook which details everything you need to know, including your options regarding staff, renegotiating debt terms, and much more.
At Inquesta, we are committed to putting the needs of our clients above all else. This is why we will take the time to gain a thorough understanding of your individual circumstances before recommending what we believe is the best course of action for you. No hidden agenda, just a service that delivers every step of the way.
For more information about how Inquesta can help, contact a member of our team today or request a free, no obligation, consultation.