In this article
How much working capital does a business need?
Enough to cover the gap between paying your costs and getting paid by customers, plus a buffer for surprises. A practical way to estimate it is to add up your monthly operating costs, multiply by the number of months of cushion you want, and add any extra needed to fund growth, such as stock for a larger order.
Ask ten owners how much working capital they need and you will get ten gut-feel answers. A better approach takes about an hour with last year's numbers, and it tells you not only what you need but also when you need it. That second part is what tells you which kind of financing, if any, fits.
What working capital is
Working capital = current assets − current liabilities. Current assets are what you expect to turn into cash within a year: cash, receivables and stock. Current liabilities are what you owe within a year: supplier bills, payroll, taxes, short-term debt and the next twelve months of loan payments.
A positive number means you can cover near-term obligations from near-term assets. A thin or negative one means you rely on incoming sales to pay bills, which is fine when customers pay quickly and risky when they do not.
A quick health check: the current ratio
Current ratio = current assets ÷ current liabilities. A ratio above 1.0 means assets exceed liabilities. Many advisers like to see a comfortable margin above that, but what is normal varies a lot by industry: a restaurant with fast-turning stock looks very different from a manufacturer holding inventory for months.
The cash conversion cycle
How much you need depends on how long your cash is tied up. The cash conversion cycle measures it in days:
- Days inventory outstanding: how long stock sits before it is sold
- Days sales outstanding: how long customers take to pay
- Days payables outstanding: how long you take to pay suppliers
Cycle = inventory days + receivable days − payable days. The longer the cycle, the more cash the business needs to carry. Shortening it, by selling stock faster, invoicing sooner or negotiating longer supplier terms, frees cash without borrowing.
A worked example
A small distributor has monthly operating costs of $80,000. It wants a cushion of two months, so $160,000 in cash or credit available. It holds $90,000 in cash and expects to be paid $70,000 by customers in the next 30 days. A large new order needs $40,000 of stock bought and paid for before the customer pays in 45 days.
- Cushion target: $160,000
- Current cash: $90,000
- Shortfall against the cushion: $70,000, which is covered once the $70,000 of receivables arrives within 30 days
- Extra funding for the new order: $40,000 for about 45 days
The real need is not $200,000; it is roughly $40,000 for six weeks, plus a decision about whether to keep a standing buffer. That points to a short-term working capital loan or a line of credit, not a large term loan.
Ways to close a shortfall
- Improve the cycle: collect faster, hold less stock, ask suppliers for longer terms. See our cash flow guide.
- A line of credit for repeating gaps, since you pay only for what you use.
- A working capital loan for a defined, one-time need. Read more in working capital loans in Canada.
- Invoice financing if the cash is locked up in unpaid invoices. See invoice financing vs. factoring.
- Equity or retained earnings if you would rather not take on debt.
Review it regularly
Redo the calculation every quarter, or before any big change such as a major order, a new location or the start of your busy season. Working capital needs change as the business grows, usually faster than owners expect.
