How is working capital calculated?

The question: how is working capital calculated?

What we are trying to do here is answer the question (perhaps first pitched at the finance director) which asks: "how much short term funding would you need to run this business?" Here are some ways of finding the answer.

1. Look at the management accounts

Interim management accounts will detail operating balance sheet items that have an impact on the short term funding requirement for the business, including debtors and creditors. The excess of debtors (the people who owe the business money = a funding requirement) over creditors (the people who the business owes money to = a source of funding) represents a net funding requirement for the business.

As the business grows, debtors go up, more people owe the business money, and its short term funding requirement increases.

2. Look at the bank statements

There are other ways of estimating the working capital requirement. One of the main ones is to look at the bank statements, adding back items that are involved with the long term financing of the business, so that we are only left with entries that relate to short term operations.

Looking at the bank statements will tell you about within period fluctuations which are often greater than the between period fluctuations in the management accounts.

3. Construct a cash flow forecast

None of the above takes account of expected future growth for the business. In a growing business, forecasting forward sales, debtors and the cash flow required to fund those debtors could lead to a much higher estimate for working capital requirements. Considering the history is not enough. At Financial Training Associates we regularly run training courses for bankers who wish to construct fully integrated financial models in Excel. They don't want to take a proposal to their credit committee, lend to a business and find it unexpectedly asking for more money immediately post deal.

4. Ask the finance director.

A good finance director will be monitoring his cash flow and will know what the swing within the year is. "Ask the finance director" was suggested to me by a very experienced banker in one of my class rooms once, when we were talking about ways of determining working capital. I hadn't expected that answer. I had been expecting to hear about one of the other three methods detailed above. Foolishly perhaps, I asked a question: "What do you do if he doesn't know the answer?". Again, I expected to hear about one of the methods outlined above. "Get another finance director" was the dry response that came back! It was a very good answer and so asking the finance director is on my list permanently now!

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