One of the most important questions a business owner can ask is: How much working capital does my business need to grow safely?
The answer is more complicated than simply keeping a certain amount of money in the bank. Working capital is the money available to operate your business, pay employees and suppliers, purchase materials, cover overhead, and take advantage of new opportunities while you wait for customers to pay their invoices.
A business can be profitable and still have a working-capital shortage. In fact, rapid growth can make a cash-flow problem worse because every new sale may require the company to spend money before collecting the revenue.
For businesses that sell to other businesses on Net 30, Net 60, or longer payment terms, understanding working capital is particularly important.
What Is Working Capital?
Working capital is generally calculated by subtracting current liabilities from current assets.
Working Capital = Current Assets − Current Liabilities
Current assets typically include cash, accounts receivable, inventory, and other assets expected to be converted into cash within a year. Current liabilities include obligations such as accounts payable, payroll, taxes, and other short-term expenses.
However, business owners should look beyond the accounting formula.
The real question is:
“Will I have enough available cash to pay my bills while I wait for my customers to pay me?”
That is the question that determines whether your company can comfortably support its current operations and future growth.
Why Profitable Businesses Can Still Run Out of Cash
Imagine your company completes $200,000 of work this month and sends invoices to customers with Net 60 payment terms.
Your income statement may show $200,000 in revenue.
Your accounts receivable may increase by $200,000.
But your bank account does not necessarily increase by $200,000.
You may have to wait two months before receiving the money.
During those two months, your company still has to pay:
- Employees and payroll taxes
- Suppliers and vendors
- Rent and utilities
- Insurance
- Equipment expenses
- Materials
- Subcontractors
- Taxes
- Marketing and other operating expenses
This creates the working-capital gap.
The larger your sales become, the larger that gap can become.
Growth Can Increase Your Need for Working Capital
Many business owners assume that increasing sales automatically improves cash flow.
Not necessarily.
Suppose your company generates $1 million in annual sales. Your customers pay, on average, 45 days after receiving your invoices.
Now imagine you grow to $2 million in annual sales.
That is a significant accomplishment—but your accounts receivable may also grow substantially.
You are now funding more customer purchases while waiting for those customers to pay.
This is especially common in:
- Staffing companies
- Manufacturing companies
- Oil and gas service companies
- Distributors
- Government contractors
- IT and technology companies
- Business services companies
For example, a staffing company may have to pay employees every week while its customers pay invoices 30 or 60 days later.
Winning a large new contract can therefore create an immediate need for additional working capital.
The business is growing—but the cash needed to support that growth may not arrive for weeks.
So How Much Working Capital Do You Need?
There is no universal number that works for every business.
A better approach is to calculate your working-capital requirement based on your operating cycle.
Start by determining how much cash your company typically needs each month to operate.
Include:
- Payroll
- Payroll taxes
- Rent and utilities
- Inventory and materials
- Vendor payments
- Insurance
- Equipment expenses
- Taxes
- Debt payments
- Other recurring operating expenses
Then determine how long it takes your customers to pay.
If your customers take an average of 45 days to pay, you may need enough working capital to cover a significant portion of your expenses during that collection period.
Your cash requirement can become even larger when sales are increasing rapidly.
Don’t Forget About Your Accounts Receivable
One of the biggest mistakes business owners make is looking only at the cash in their bank account.
Your accounts receivable may represent a significant amount of money that your company has already earned.
If you have $500,000 in outstanding invoices, for example, that money is valuable—but it isn’t immediately available to pay today’s payroll or tomorrow’s supplier invoice.
That is why accounts receivable management is such an important part of working-capital management.
Businesses should regularly monitor:
- Total accounts receivable
- Average days to payment
- Aging of invoices
- Past-due invoices
- Customer credit quality
- Concentration among major customers
- Expected collections over the next 30, 60, and 90 days
The goal isn’t simply to generate more invoices.
The goal is to turn those invoices into cash as efficiently as possible.
What Happens When Working Capital Is Too Low?
A working-capital shortage can create a domino effect.
A company may delay paying a supplier.
The supplier may tighten payment terms.
The company then needs more cash to purchase materials.
At the same time, the business may delay hiring because it doesn’t have enough money to fund payroll.
Eventually, the company may even turn down profitable business because it cannot afford the costs required to perform the work.
That is one of the most frustrating situations a business owner can face:
You have customers. You have sales. You have opportunities. But you don’t have enough cash to take advantage of them.
The problem isn’t necessarily profitability.
It is liquidity.
How Invoice Factoring Can Increase Available Working Capital
For businesses with creditworthy commercial customers, invoice factoring can provide a practical way to increase available working capital without waiting for customers to pay.
Instead of waiting 30, 60, or 90 days, the business can access a substantial portion of the invoice value much sooner.
American Receivable, for example, provides working capital by advancing money tied up in unpaid invoices. Its programs can provide advances of up to 95% of eligible invoices, depending on the specific circumstances of the client and its customers.
The process generally works like this:
1. Complete the work.
You provide the products or services to your customer.
2. Send the invoice.
You invoice your customer according to your normal billing terms.
3. Submit the invoice for factoring.
The factoring company verifies the invoice and customer.
4. Receive your advance.
You receive immediate working capital rather than waiting for the customer to pay.
5. Customer pays the invoice.
The customer pays according to the established payment terms.
6. Receive the remaining reserve.
After the invoice is collected, the factoring company releases the remaining balance, less the applicable factoring fee.
This can turn accounts receivable into a more predictable source of working capital.
Factoring Can Help Working Capital Grow With Your Sales
One advantage of invoice factoring is that financing can grow as your sales grow.
A traditional loan may provide a fixed amount of capital.
But your working-capital needs may change significantly as your business expands.
If your company goes from $500,000 in annual sales to $1 million, your need for working capital may increase substantially.
With invoice factoring, the financing is connected to eligible accounts receivable.
That can make factoring particularly useful for companies experiencing rapid growth.
American Receivable offers factoring programs ranging from smaller working-capital needs to credit lines of up to $5 million, depending on the company’s receivables and qualifications.
How Much Cash Should You Keep in the Bank?
Invoice factoring shouldn’t replace good financial management.
Every business should maintain an appropriate cash reserve based on its industry, expenses, customer payment patterns, and risk profile.
You should also maintain a rolling cash-flow forecast.
A useful forecast should show:
Cash coming in − Cash going out = Expected cash balance
Project this at least 13 weeks into the future.
A 13-week cash-flow forecast can help you identify upcoming shortages before they become emergencies.
If you know that payroll will increase next month because you’re hiring 20 employees, for example, you can determine how much additional working capital you will need before the payroll date arrives.
The Bottom Line: Working Capital Should Support Your Growth
The right amount of working capital isn’t simply the largest amount of cash you can accumulate.
It is the amount of liquidity you need to operate comfortably, handle unexpected expenses, meet your obligations, and pursue profitable opportunities without constantly worrying about when customers will pay.
If your company is growing quickly, your working-capital needs may increase faster than your profits.
That is why business owners should monitor both profitability and liquidity.
And if your largest asset is accounts receivable, you may already have much of the working capital you need—it may simply be tied up in unpaid invoices.
Need More Working Capital to Grow Your Business?
American Receivable has been helping businesses turn accounts receivable into working capital since 1979. We provide customized invoice factoring programs for businesses that need reliable cash flow to fund payroll, purchase inventory, accept larger contracts, hire employees, and continue growing.
Our factoring programs can provide fast access to capital, competitive rates, flexible funding, and no long-term contracts.
If your business has strong sales but cash flow is holding back your growth, don’t wait until a cash shortage becomes an emergency.
American Receivable — Turning Your Receivables Into Working Capital Since 1979.
