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Guide to Working Capital Requirement

What Is Working Capital Requirement (WCR)?
Susan Guillory
Susan GuilloryUpdated September 6, 2023
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When your business finances are aligned, meaning you’ve got enough money coming in to cover your expenses, it’s like a well-oiled machine. When those finances are out of sync, your machine may lurch along, with the threat of failure just a couple of invoices away.Revenues and expenses are a delicate balance. The trick is understanding the amount of working capital you need in the short term to ensure you can pay your bills.  To that end, it can be helpful to understand working capital requirements. Keep reading to learn what working capital requirements are and how they can ensure your business is operating as it should.

What Is Working Capital Requirement?

Working capital is what’s left in current assets after you pay your current liabilities, like vendor invoices, taxes, and loan payments. The mathematical formula for working capital is simply current assets minus liabilities.Your working capital requirements (WCRs) refer to the amount of capital you need to cover those liabilities, or expenses. This requirement can change from month to month or quarter to quarter. Sometimes you have bills due before you receive payments from clients, and then what do you do?

Why Does Working Capital Matter?

In a perfect world, your clients would pay their invoices on time, giving you ample opportunity to then turn around and manage your own accounts payable. But as we know, that’s not always what happens. Sometimes clients pay late or their payment terms don’t align with the payment terms you have with your own vendors. Then you’re left with a gap between revenues coming in and money needing to go out.Another situation where it’s important to understand working capital requirement (also called net working capital requirement) is if you spend a sizable amount on inventory, but then it takes a while to actually sell all of it. You’ve made a big expenditure without a guarantee of when you’ll make your return on investment, and yet you still have bills due.When there’s a gap between assets and liabilities, it’s important to be able to plan for it before it happens. Planning ahead can help you strategize how to cover the gap, such as by applying for business loans to access the working capital you need in the short term.

Working Capital Requirement Formula

Let’s look at how to calculate working capital requirement so you can predict ahead of time how much working capital you’ll need to have on hand at any given time. 

How to Calculate Working Capital Requirement

To calculate working capital requirement, you use the same formula as you would to calculate working capital:Current Assets - Current Liabilities = Working CapitalKeep in mind that current assets aren’t always cash or liquid. They can also include inventory and accounts receivable. If you’re looking to ensure you have enough cash on hand to cover current liabilities, realize that you might want to consider taking out a working capital loan if you don’t have sufficient liquid assets to cover debts.As an example, let’s say that you have $45,000 in current assets, including cash, inventory, and accounts receivable. You also have upcoming expenses of $50,000, including a tax bill, vendor invoices, and rent for your office space.45,000 - 50,000 = - 5,000In this example, you would have a deficit of $5,000 in working capital for this period. What can you do to make up for the gap? You could light a fire under a client to get them to pay their bill, take out a loan, or ask your vendor to extend payment terms.Here’s another example. Let’s say you have the same $45,000 in assets but your expenses for this period are only $30,000. 45,000 - 30,000 = 15,000Now you have a surplus of $15,000. You can set that money aside for a future project or investment. If your WCR fluctuates, it might be a good idea to not spend it unnecessarily, knowing you’ll need it to cover future working capital requirements.Recommended: How to Get a First-Time Business Loan

Working Capital Ratio

Another useful calculation is your company’s working capital ratio. Here’s how you calculate it:Current Assets / Liabilities = Working Capital RatioThis ratio indicates how much liquidity your company has. A ratio over two is considered highly liquid, while under one may indicate issues.If your assets are $45,000 and your expenses $50,000, your ratio would be 0.9 (45,000/50,000). If your assets are $45,000 and your expenses $30,000, your ratio would be 1.5 (45,000/30,000). 

What Working Capital Requirement Indicates

Knowing how much working capital you need to cover expenses can help you plan ahead, and watching for changes in WCR can reveal important information about how your business is spending money and generating revenues over time. Being aware of these changes can help guide your financial strategy.For example, if you see a sudden and sharp rise in your working capital requirement, the business is spending more on expenses and may not have extra capital to expand operations, acquire other businesses, or develop new products. If you plan to bring on investors, they may be concerned that you may not have enough working capital in the near future to cover your increasing expenses.Look at why your WCR is rising. Is it a one-off because you’ve made a sizable investment in a project or made an unusually large inventory order? Or have your expenses risen over time without any real reason?If your working capital requirements have risen over time, you have a few avenues to explore. One is to look at different business loan types that can provide the working capital you need to cover those gaps. Another is to reduce expenditures and thereby reduce your WCR. A third option is to raise prices or create a payment policy to get your clients to pay their invoices faster.Calculating your working capital requirement can help you make smarter financial decisions for your business. By looking down the road at expected revenues and expenditures, you can take steps to ensure you always have ample working capital for your business needs.

3 Small Business Loan Tips

  1. Generally, it can be easier for entrepreneurs starting out to qualify for a loan from an online lender than from a traditional lender. Lantern by SoFi’s single application makes it easy to find a small business loan offer from a lender. 
  2. If you need to borrow money to cover seasonal cash flow fluctuations, a business line of credit, rather than a term loan, provides the flexibility you likely need.
  3. If you are launching a new business or your business is young, lenders will consider your personal credit score. Eventually, though, you’ll want to establish your business credit.

Frequently Asked Questions

What are the four key components of working capital?
What factors affect working capital requirement?
What are the requirements of working capital forecasting?
Photo credit: iStock/alfexe

About the Author

Susan Guillory

Susan Guillory

Su Guillory is a freelance business writer and expat coach. She’s written several business books and has been published on sites including Forbes, AllBusiness, and SoFi. She writes about business and personal credit, financial strategies, loans, and credit cards.
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