Understanding working capital in a small business

What is Working Capital?

Working capital is a measure of short-term liquidity that is calculated based on current assets minus current liabilities. To use an analogy, working capital for a company is similar to what gas is for your car. While technically, you have a fully functioning car without any gas, you cannot go anywhere. The gas is needed to keep the engine firing and the car moving. Working capital is the money needed to fuel your business: cover the time differences between when you spend money (e.g., pay suppliers, buy inventory, pay your credit card) and receive money (e.g., accounts receivable, financing plans given to customers, etc).

The formula for working capital is current assets minus current liabilities. Current assets consist of cash, marketable securities, accounts receivables, inventory, prepaid assets, etc. Current liabilities include accounts payable, short-term debt, deferred revenue (with an expectation that revenue will be recognized within a year), interest payable, accrued expenses, etc.

In short, working capital measures a company's ability to meet its short-term obligations. Those obligations include expenses owed to suppliers, first month expenses and any unexpected expenses not forecasted into the monthly budget. A company’s working capital calculation is used extensively by third parties (e.g., lenders, investors, analysts, etc). 

As an entrepreneur, who is wanting to purchase a small business, positive working capital, all else being equal, is preferred to negative working capital. However, more or less working capital for a company may be required depending on the industry (e.g., restaurants often have less working capital needs than a distribution company).

Is Working Capital Included When Buying a Business?

Sometimes. 

In larger business acquisitions, working capital is almost always included in the purchase price. This is done through setting a working capital peg, which is the amount of working capital that a buyer would need under normal circumstances. Right before close, the advisors will run the working capital formula (current assets - current liabilities). If the amount of working capital currently in the business is more than the peg, then the purchase price is adjusted up by that amount. If the amount of working capital is less than the peg, then the purchase price is adjusted down by that amount.

For smaller business acquisitions, working capital may not be included in the purchase price. Business owners may want to sell inventory on top of the purchase price or hold onto any accounts receivable earned during their tenure. While this will affect the purchase price a buyer can afford, the buyer will still need to come up with working capital from other sources.

In a recent survey of SMB buyers, around 27% of buyers brought in working capital through an additional loan or line of credit, 27% of buyers were able to get working capital included by the seller, and 46% funded working capital with their own money.

How Much Working Capital Do I Need When Buying a Business?

The amount of working capital needed when buying a business depends on the industry the business is operating in, the maturity of the business and current market conditions. For example, current market conditions would indicate that, on average, a buyer would need a higher working capital level than a few years ago because borrowing costs are significantly higher. Thus, making it more difficult to raise capital when the business may need it the most. 

When forecasting working capital needs for a deal, it’s important to review monthly balance sheets. This will allow you to spot any seasonality and better understand whether Net Working Capital is increasing (meaning more cash is being used) or decreasing (meaning less cash is being used). 

Based on the normalized working capital levels across a 12-24 month period, you will be able to forecast how much working capital you need at close to “fuel the engine” of your new business. If you chose to leverage a Quality of Earnings provider, this analysis will be a key part of their work.

Difference Between Working Capital and Net Working Capital (NWC)?

Unlike working capital, net working capital excludes cash from current assets. While the two calculations measure short-term liquidity, net working capital emphasizes the short-term operations of a business. Other than financial institutions, cash is not part of a business's actual operation. Therefore, to gain a true picture of a firm’s operation, an entrepreneur must strip out cash from the working capital equation.

An entrepreneur would prefer to see a positive net working capital because if it is negative, the entrepreneur may have to fund the operation themselves (through debt or equity). If working capital is negative, it means that short-term assets cannot pay off short-term obligations and if not properly managed, the company could go bankrupt. 

Entrepreneur’s need to be careful when comparing businesses because the net working capital for a technology company will be vastly different from the net working capital for a plumbing company.

With working capital and net working capital, an entrepreneur can rearrange the formula and measure working capital and net working capital as ratios. For example, the working capital ratio is current assets divided by current liabilities (also known as the current ratio). With these ratios, an entrepreneur would want to see a ratio greater than one because than that business can fund itself through its operations

Below is a table with the formulas and ratios for Working Capital and Net Working Capital:

Is Negative Net Working Capital bad for a Company?

The short answer, no. However, this question is dependent on the type of company an entrepreneur is running or looking to purchase. For example, if the company is a start-up, positive working capital may not be possible due to high growth. In addition, large mature companies with strong credit and brand recognition may not have high net working capital because of its efficiency and relationships with its customers. Moreover, a company in an industry with high deferred revenues (say a subscription business like netflix) may have a low or negative working capital. These companies are unique because of how their normal business operations are structured.

More importantly though, a small amount of working capital or net working capital could mean that the firm is operating efficiently and will be able to take advantage of longer-term projects.

Ways to Support or Improve Working Capital

There are many ways an entrepreneur can support or improve its businesses working capital operations.

• One improvement could be with its accounts receivable policy, where the business stipulates to its customers that they must pay within 20 days instead of 30 days. An updated policy improves turnover ratios and the business receives cash sooner rather than later.

• Another way to improve working capital is to develop a strong relationship with a financial institution and gain cheap financing through a loan or line of credit. In fact, many small businesses have a working capital line of credit (similar to a credit card) with their financial institution to help manage their working capital.

The working capital line of credit allows a company to decrease the volatility inherent in its operations by providing a steady stream of cash to fund its day-to-day operations. Thus, reducing the risk of insolvency.

Other Measurements from Working Capital

There are many ratios and measurements within working capital that an entrepreneur can use to better evaluate a prospective business for purchase. Common ratios are turnover ratios such as inventory turnover, receivables turnover and accounts payable turnover. These turnover ratios are often used to calculate days sales outstanding, days inventory outstanding and days payables outstanding. Those three ratios are used to calculate the Cash Conversion Cycle (CCC).

The CCC is used to calculate the number of days it takes for a business to convert cash into sales and then sales back into cash. The CCC paired with working capital are two key metrics to analyze efficiency of a business.

Summary of Efficiency Ratios

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.