How much working capital does my business need?

There is no single right number. The amount depends on how long your cash is tied up, how uneven your year is and how much of a cushion you want. You can build a sound estimate from three parts.

The three parts of the estimate

1. The operating gap. The cash you need to carry your costs between paying them and getting paid.
2. Seasonal and one-off needs. Stock you build before a busy period, quarterly BAS payments, annual insurance and similar lumps.
3. A buffer. A cushion for a late-paying customer, a quiet month or an unexpected repair.

Part 1: the cash conversion cycle

The cash conversion cycle measures, in days, how long your money is tied up. It has three pieces.

• Debtor days: how long customers take to pay you. Work it out as money owed by customers, divided by annual sales, times 365.
• Stock days: how long stock sits before it sells. Work it out as stock on hand, divided by annual cost of goods sold, times 365.
• Creditor days: how long you take to pay suppliers. Work it out as money owed to suppliers, divided by annual purchases, times 365.

Cash conversion cycle = debtor days + stock days − creditor days.

A service business with no stock skips stock days. It still has a gap if it pays wages weekly and invoices monthly.

To turn days into dollars, multiply the cycle by your average daily cash costs. These are everything you pay out to run the business (stock, wages, rent and overheads), divided by 365 or by the days in the period.

A worked example

A business with $1,200,000 in annual sales has these figures.

Measure	Figure
Debtor days	45
Stock days	30
Creditor days	30
Cash conversion cycle	45 + 30 − 30 = 45 days
Cash costs each month	$90,000 (about $3,000 a day)

Operating gap: 45 days × $3,000 = $135,000.

Seasonal need: before Christmas the business buys an extra $40,000 of stock, which it pays for before those sales come in.

Buffer: the owner and their accountant settle on about one month of fixed costs (rent, wages and other overheads that don’t fall when sales do). Here that is about $30,000.

Estimated need at the peak: $135,000 + $40,000 + $30,000 = $205,000.

The balance sheet shows current working capital of $150,000, so the business is about $55,000 short at its busiest time.

Before looking at finance, the owner tests what would happen if customers paid faster. Cutting debtor days from 45 to 35 brings forward about 10 days of sales. At $1,200,000 a year, that is roughly $33,000, which closes more than half the gap.

These are round numbers to show the method. Your own figures will be less tidy, and your accountant can help you check them.

Seasonal needs

A single annual figure can hide the months that hurt. Build a month-by-month cash flow forecast for the next 12 months. business.gov.au suggests a cash flow statement to forecast what is coming in and going out. Mark:

• the months you buy extra stock or take on extra staff
• the months when sales are slow
• tax and super due dates
• large annual bills, such as insurance and registrations.

The lowest point in the forecast is the figure to plan for.

Signs you’re short of working capital

The business.gov.au list of warning signs includes customers often paying late, finding it hard to pay suppliers or debts such as loans or taxes, and not being able to pay yourself a salary. Other signs are:

• paying suppliers only after a reminder
• using the money set aside for GST or super to cover other bills
• sitting at your overdraft or card limit most of the month
• turning down orders because you can’t pay for the stock or staff
• putting personal money into the business to cover wages.

If several of these apply, read cash flow warning signs.

Step by step

1. Pull your latest balance sheet and profit and loss statement for the last 12 months.
2. Calculate debtor days, stock days and creditor days, then your cash conversion cycle.
3. Work out your average daily cash costs and multiply by the cycle.
4. Build a 12-month cash flow forecast and find the lowest point.
5. Add the seasonal needs and agree a buffer with your accountant.
6. Compare the total with your current working capital (current assets minus current liabilities). See what is working capital?
7. Test what faster collections, lower stock or longer supplier terms would free up.
8. Only then decide whether a gap remains and how to fund it.

If a gap remains

If the gap is temporary and repeats, such as a seasonal stock build, a business line of credit is one option, because you draw it when needed and pay it down after. If the gap is permanent, for example because the business has grown, a longer-term arrangement may suit better, such as business loans or working capital finance. Our guide to a line of credit vs a term loan compares the two, and how much can my business borrow? explains how lenders look at it.

If the shortfall comes from losses rather than timing, borrowing will not close it. Read when borrowing is not the answer.

Important things to know

• This is an estimate, not a precise figure. Recalculate it at least once a year, and whenever sales, terms or stock levels change.
• Growth increases the need. More sales usually means more money tied up in stock and unpaid invoices before the cash arrives.
• A single large customer changes the picture. If one customer owes a large share of your receivables, a delay from them can undo your whole buffer.
• Don’t count money you owe to others. GST, PAYG withholding and super you have collected or owe are not spare working capital.
• Get help with the numbers. Your accountant or bookkeeper can check your calculations and forecast.