How much working capital should I take?
Sizing a request to the real need.
Guide
The working capital formula, and what to do with the answer
Working capital is a number you can compute in five minutes from your balance sheet, and it predicts whether a late invoice is an annoyance or a crisis. Here is the formula, the ratio, and what to do when the answer is thin.
The formula
Working capital = current assets − current liabilities
- Current assets: cash, accounts receivable you expect to collect within a year, inventory, prepaid expenses.
- Current liabilities: accounts payable, credit-card balances, the next twelve months of loan or advance payments, accrued payroll and taxes, customer deposits you have not earned yet.
Example: $18,000 cash + $32,000 receivables + $10,000 inventory = $60,000 current assets. $22,000 payables + $9,000 card balance + $26,000 of advance payments due this year = $57,000 current liabilities. Working capital: $3,000. That business is one slow customer away from missing payroll.
The ratio
Working capital ratio (current ratio) = current assets ÷ current liabilities. The example above is 1.05. Rules of thumb: below 1.0 means you cannot cover the next year's obligations from what you have; 1.2–2.0 is comfortable for most service and retail businesses; above 3.0 may mean idle cash or bloated inventory. Inventory-heavy businesses should also compute the quick ratio (excluding inventory), because inventory is not cash until it sells.
What funding does to the number
An advance adds cash (current asset) and adds the full payback amount due within a year (current liability). Because payback exceeds cash received, an advance lowers working capital the day you sign. A term loan with payments spread over several years adds cash now and only the next twelve months of payments to current liabilities, so it usually raises working capital. This is the balance-sheet reason short products should fund short needs.
| Funding | Cash added | Current liability added | Working capital change (day one) |
|---|---|---|---|
| $20,000 advance, 1.25 factor, 26 weeks | $19,600 | $25,000 | about −$5,400 |
| $20,000 3-year term loan at 12% | $19,400 (after 3% fee) | about $8,000 (12 months of payments) | about +$11,400 |
How to improve it without borrowing
- Invoice the day the work is done and offer a small discount for payment within 10 days.
- Negotiate net-30 or net-45 with suppliers; every day of terms is free working capital.
- Cut slow-moving inventory; it is cash sitting on a shelf.
- Require deposits on custom work.
Then, if a gap remains, fund it with the right structure for its length.
Common questions
Is negative working capital always bad?
Not always. Businesses paid up front by customers (subscriptions, restaurants) can run slightly negative safely because cash arrives before bills. For businesses that invoice on terms, negative working capital is a warning.
How much working capital should a small business have?
Enough to cover the gap between paying for work and getting paid for it, plus a buffer for one bad month. For many businesses that means one to three months of operating expenses in cash and near-cash.
Related
Working capital funding
Advances, loans, and lines.
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