The economic uncertainty over the COVID-19 pandemic has many business owners asking Evergreen Working Capital this question. No matter what industry you’re in, you don’t know what level of working capital is adequate until you get down to the company level.
The litmus test for working capital is if a company can meet monthly obligations without any financial stress in the ordinary course of business, then working capital is adequate, whatever that exact number is. On the other hand, if you find yourself unable to pay vendors or the bank on time, or if making payroll is a struggle, then you probably have a working capital deficit and need to evaluate the situation.
Here’s how we like to think about working capital.
A better way to define working capital
At Evergreen, we view working capital as capital available to support current assets.
We look to the long-term section of the balance sheet to calculate working capital because it’s the epicenter of working capital. If you’re looking at cause and effect, the cause of working capital is having more capital (long-term debt + equity) than the amount required for long-term assets.
To see the impact of working capital, we start with the basic accounting equation: Assets = Debt + Equity. Stated another way, every dollar of assets must be supported by a dollar of debt or equity.
To look at working capital, we separate current assets and current debt from the long-term portion of the balance sheet.
It is true you get the same result whether you measure working capital in the current section of the balance sheet or the long-term section. However, we prefer to focus on the long-term section of the balance sheet because if you need to increase working capital, this is where the work needs to be done.
Level of working capital depends on the business
The amount of working capital needed in a business constantly varies with changes in asset requirements. Most of the demand for assets in a business comes from sales operations. As sales volume changes, the level of assets and need for supporting funds varies accordingly.
Short-term borrowing can work temporarily, but adding short-term debt does not increase working capital, so it’s more of a band-aid for the issue. Permanent growth in current assets requires a long-term funding solution.
Finding new sources of working capital
Profitability is a great source of working capital because it increases equity and it is organic, but it is not always enough. When more is needed, companies can generate working capital in many ways:
- Sell any unessential fixed assets to free up cash
- Increase long-term debt by refinancing or borrowing against the company’s fixed assets. Some business owners refinance their home and then invest the money in their company as either debt or equity to increase the capital.
- Borrow long-term money using a government guarantee program, which could be a traditional SBA loan or disaster relief loan
- Raise equity or long term loans from friends, relatives or outside investors
There is an alternative to raising working capital. It’s called factoring. Rather than sit on accounts receivable, a growing business can sell those invoices to a factoring company for immediate cash. That cash flow is immediately available to pay the operating expenses of the business. With factoring, you’ve eliminated an unnecessary asset and reduced the need for more working capital. The advantage is the business can use someone else’s capital to grow its operation.