Did you know that Australian companies have reduced working capital by more than $3.4 billion in 2020? Without sufficient working capital, Australian start-ups are suffering. Despite this, only 0.05% of startups raise outside capital.
Yet, businesses that lack a line of credit rely on accounts receivable to cover their current liabilities. This feast and famine approach is not only stressful but also unsustainable.
So how much working capital does the average start-up really need? More importantly, how much is the minimum working capital required to generate the most sales?
What is Working Capital?
Working capital is essential for any business, whether you are part of a start-up, family business, or well-established international corporation. It refers to the amount of money spent to improve net sales after bills and debts are paid.
Working capital is composed of your current assets minus current liabilities. As a quick recap, assets refer to what your company owns, such as cash and stock. On the other hand, liabilities refer to what your company owes, including accounts payable and salaries.
Therefore, working capital is the ‘spare cash’ left over to be re-invested into the business in order to boost sales. It may be spent on improving the efficiency of internal operations and processes. Alternatively, companies may choose to pledge working capital towards new machinery or software, for example.
A start-up often requires outside funding to generate enough working capital to support its sales growth. Therefore, calculating the current and expected working capital turnover ratios could be key in securing that funding.
Working Capital Turnover
Working capital turnover compares the proportion of net sales to working capital. This is known as the working capital turnover ratio.
In reality, the ratio measures how efficiently your money is working to generate more capital. A higher-than-average working capital turnover ratio indicates that every pound (or dollar) of working capital spent delivers a better return in net sales.
Even better, you can compare the calculation for your working capital turnover with that of your competitors in the same industry. Does their cash work harder? Why?
How to Calculate your Working Capital Turnover Ratio
Calculate working capital by subtracting current liabilities from current assets.
The working capital turnover ratio formula is as follows:
Net Sales / (Total Assets minus Total Liabilities)
In this way, the amount of sales is directly related to the company’s current assets and liabilities. Therefore, we are really looking at how you make the spare capital work, and whether it’s generating enough sales to cover your liabilities.
What your Working Capital Turnover Ratio Means
The goal here is to have a high ratio of working capital turnover. A higher ratio indicates a strong financial outlook for your company, as the funds spent have generated an ideal number of net sales over the period.
Some startups, however, may have calculated their working capital turnover ratio to be in the negatives. While it’s not ideal, there are a number of ways to overcome this and later generate a high turnover ratio.
Working capital performance for Aus/NZ companies has plateaued. According to a 2017 survey, 44% of companies saw their working capital performance deteriorate by more than 5%. This indicates that those who do not have a strategy around improving their working capital turnover are at risk of being left behind.
A high working capital turnover is important for showing that a company is utilising its working capital in the most efficient way.
How to improve your Working Capital Turnover Ratio
It can be useful to track the working capital turnover ratio over the short term (for example, on an annual basis) as this will allow management to calculate improvements over the given period.
However, there are steps you can take right now to implement a strategy around improving your company’s working capital turnover.
Offer Deferred Revenue Incentives
Do any of your customers pay you prior to receiving your services? Deferred payments increase your capital and provide your company with up-front cashflow. While deferred revenue will appear as a liability on your accounts statements, it can be a great method of generating credit.
To incentivise customers into upfront payments, offer a discount or set expectations in your client agreement. Managing this will directly lead to higher working capital.
Increase Days Payable Outstanding
Days payable outstanding refers to the number of days a company goes before settling its account. As a start-up, having a high days payable outstanding is beneficial as it means you are utilising the entirety of the credit period. This frees up working capital to fuel business growth.
Each industry has different operations standards when it comes to days payable outstanding. But repaying accounts on time is incredibly important. So, optimise your accounts payable and negotiate terms in order to access working capital and build a good business credit history.
Avoid Stockpiling
Keeping an inventory is essential for any product-based business. But when you overcommit, it can be hard to shift the product. While it’s not a major issue in the long term, stockpiling can lead to short-term cashflow problems.
Inventory management can play a key role in maintaining higher working capital. Companies that can accurately calculate when stock is required are more likely to have efficiency across their entirety of operations. This helps maximise the working capital left after subtracting liabilities from assets.
How to Acquire Initial Working Capital
Almost 77% of North American companies used personal funds to finance their startup costs in 2018. But for sustainable growth, this may not be the best option. Plus, the heavy investment required for self-funding leads to questions over the accessibility of being an entrepreneur.
Instead, we recommend applying for external capital. R&D Financing is not only tax-efficient but is also a serious contender for start-ups who need to plug their expenses. The tax credit is a sustainable source of operating cash for many firms, every year.
While the R&D tax credit scheme has often been slow to materialise in the past, it can now be reliably accessed within just a few weeks. So if your business is in need of a cash injection, apply now.
