What is Working Capital Requirement? A Guide for Business Owners
No matter how good your sales are, your company will face insolvency if you can’t access working capital to pay current financial obligations. Assessing your company’s working capital determines how much is available to meet short-term obligations, seize opportunities, and navigate challenges effectively. Calculating working capital requirements tells you how much of that capital is needed to support day-to-day operations and maintain business activities.
Regularly monitoring working capital requirements will aid in developing a forward-looking view and assist in planning to help ensure working capital is available when needed to support operations and what remaining capital can be used to invest in long-term initiatives.
Read on to discover how to calculate and assess working capital requirement. Plus, learn how businesses leverage alternative business financing to maximize access to working capital to pay bills and invest in future growth.
Working Capital vs Working Capital Requirement
Both working capital and working capital requirement are key concepts for a business – they are interlinked yet distinct.
Working capital is a metric to determine a company’s liquidity, the amount of cash, cash equivalents, and other current assets a business has available after all its current liabilities are accounted for. A common way to analyze your working capital is by calculating the current ratio:
Working capital current ratio = Current assets / Current liabilities
A working capital ratio greater than 1.0 means the company’s assets are kept ahead of its short-term debts. A working capital ratio somewhere between 1.2 and 2.0 is generally considered good. However, this varies depending on the industry.
Working capital requirement (WCR) is the amount a business needs to cover its operating expenses. It represents the company’s current inventory, accounts receivable, and accounts payable. It is a simple formula:
Working capital requirements = Inventory + Accounts receivable – Accounts payable
There can be three different scenarios, depending on the difference between your current assets and your current liabilities:
- If your WCR is positive, your company lacks sufficient funding to meet its short-term liability requirements.
- A WCR of zero indicates that your company has enough operational resources to cover all requirements.
- If your WCR is negative, your company has more access to working capital than needed to pay current liabilities.
The difference between “working capital” and “working capital requirement” is the availability of capital vs. capital need.
How to manage working capital requirement
Businesses should regularly monitor their working capital position, such as monthly or quarterly. Regular monitoring helps to identify trends, seasonal fluctuations, and potential issues early on, allowing for timely adjustments.
A negative WCR indicates that a company maintains the necessary resources to operate effectively, meet short-term obligations, and pursue opportunities for success. However, a significantly low WCR could indicate that the company needs to utilize its resources more efficiently or could be overly cautious in managing its working capital.
A positive WCR is a red flag indicating potential cash flow or liquidity issues. Specifically, suppose the working capital required to pay liabilities is rising. In that case, this shows a narrowing gap between your working capital and the working capital you need to manage your liabilities.
Here are some steps you can take to address and avoid a potentially positive working capital requirement:
- Analyze the Situation
- Identify the specific factors contributing to the positive WCR, such as high accounts payable, low accounts receivable turnover, or excessive inventory levels.
- Determine whether the higher working capital need is a short-term or a systemic problem requiring more comprehensive solutions.
- Improve Accounts Receivable Management
- Implement more effective credit and collection policies to accelerate the collection of outstanding invoices from customers.
- Offer discounts or incentives for early payments to encourage prompt settlements.
- Evaluate and potentially adjust credit terms to minimize the time customers take to pay.
- Optimize Inventory Management
- Streamline inventory management practices to reduce excess inventory levels and associated carrying costs.
- Implement just-in-time (JIT) inventory systems to align inventory levels more closely with actual demand.
- Identify slow-moving or obsolete inventory and consider strategies to liquidate or repurpose it.
- Negotiate with Suppliers
- Work with suppliers to negotiate more favorable payment terms, such as extended payment deadlines or discounts for early payments.
- Consider forming strategic partnerships with key suppliers to enhance collaboration and flexibility.
- Improve Operational Efficiency
- Focus on improving operational efficiency to reduce costs and enhance cash flow.
- Evaluate processes and workflows to identify areas for optimization and cost reduction.
- Rework Pricing Strategies
- Review and adjust pricing strategies to reflect the company’s costs, market conditions, and desired profit margins.
- Consider whether price adjustments can improve cash flow without negatively impacting sales.
- Explore Financing Options
- Explore alternative financing options, such as revolving lines of credit or working capital loans, to bridge cash flow gaps.
Continuously monitor your cash flow, working capital position, and progress toward resolving a positive working capital requirement result. Be prepared to adjust and adapt strategies as needed based on changing circumstances.
If the company’s cash flow requirement is positive, it is a severe and possibly complex situation. Consider seeking guidance from financial consultants, accountants, or business advisors specializing in turnaround management. To explore alternative financing options, consult with fintech companies experienced in financing the industry your company serves.
Accessing working capital to bridge the gap
Businesses struggling with positive WCR need fast, flexible financing from reliable funding sources to invest in improved efficiency initiatives. In today’s tight credit market, these businesses face arduous qualification requirements from traditional lenders, limiting their chances of credit approval.
Fortunately, fintechs are forging new avenues to fast, flexible financing to meet the capital needs of businesses requiring a rapid funding solution. Fintechs have gained significant market share over the past two decades as flexible lending alternatives to conventional means. Qualification is fast and easy for lending facilities, and funding often includes minimal loan covenants and expandable credit limits.
Let’s take a look at several funding strategies these alternative lenders provide to businesses in need of working capital solutions to bridge funding gaps:
Leverage the value of your invoices
On average, it takes over 40 days for business customers to settle outstanding invoices. This pattern of delayed payments stagnates cash flow and creates funding gaps, limiting access to working capital.
Invoice factoring is the selling of accounts receivable invoices at a discount in exchange for immediate payment. This funding process is supported by advanced technology to swiftly verify invoices, approve funding requests, and transfer funds within hours. Invoice factoring maximizes cash flow to provide easy access to working capital.
Unlock the value of your assets
Asset-based lending (ABL) unlocks the value tied up in your business assets to provide a flexible line of credit with few covenants. Your business’s AR, equipment, inventory, and more hold untapped value that can be utilized to gain financial stability.
ABL is growing as a preferred funding source for businesses needing fast, easy access to working capital. This type of lending is formula-driven against the value of the business’s assets. For example, a company may have an ABL credit facility that allows it to borrow up to 85% of its accounts receivable, and 75% of its inventory and the appraised value of its equipment.
ABL supports businesses in all stages, from young, growing companies to long-standing businesses that may recently have been facing financial challenges.
Access flexible lines of credit
Lines of credit are essential for managing short-term cash flow needs. Compared to traditional lenders, alternative finance companies are often more willing to provide lines of credit to businesses with lower credit scores or less established credit histories. These lines of credit come with flexible underwriting standards, faster funding times, higher credit limits, and require less collateral. They allow businesses to draw funds as needed, with minimal reporting requirements and covenants. companies can qualify quickly to access the cash they need to cover working capital requirement shortfalls.
For business owners, understanding working capital requirement is more than just knowing a financial metric—it’s about ensuring the heart of your business, its daily operations, keeps beating. Regularly assess your WCR, especially before major financial decisions, to gain valuable insights and help prevent unforeseen liquidity challenges.
If your business is experiencing positive WCR, take immediate action to adjust operational efficiencies and, or correct cash flow issues. Businesses with complex or severe issues should seek guidance from financial professionals who specialize in turnaround management and fintech companies experienced in your company’s industry.
eCapital is an alternative lender leading the advancement of fintech technology to provide fast, easy-to-manage business financing solutions. With a team of over 700 experts and proprietary, industry-leading technology, eCapital is creating the future of business lending. With a full suite of products such as invoice factoring, asset-based lending, lines of credit, and much more, eCapital ensures businesses have the funds they need to succeed.
For more information about how our experienced team supports small and medium-sized businesses with custom financial solutions, visit eCapital.com.