Working Capital Requirement (WCR) is a key management concept, used to determine the amount of financial resources a company needs to manage the gap between its cash outflows and its cash inflows. In other words, it determines how much cash you need to avoid short-term difficulties.
Definition of Working Capital Requirement (WCR)
The working capital requirement represents the amount of money needed to cover current operations linked to the company's commercial activity, also known as the operating cycle. For a company, expenditure (purchase of raw materials or products, operating costs, salaries, etc.) is very often necessary before it can generate sales.
To avoid defaulting on payments, a company must have the financial funds necessary to settle its existing debts at any time: a minimum cash position that can be calculated precisely at any given moment. If this is not the case, or to mitigate the risk of a sudden shortfall in cash, you can take out an overdraft facility with your bank (link to related article) - the equivalent of a short-term loan that provides a cash advance.
How do you calculate your working capital requirements?
The cost price of the business includes the value of inventories and all debts. The latter include debts contracted with suppliers for purchases on credit, as well as social debts[1] - owed by the company. We can talk about current liabilities, which can be compared with current assets, i.e. the company's receivables: payments due from customers and any other existing receivables.
The calculation can be presented as follows:
WCR = inventories + trade receivables + tax receivables + other receivables − trade payables - tax payables - social security payables - other payables
It should be pointed out that the amount of working capital required may depend on a number of factors, such as the business sector, the average value of goods sold, the time taken to turn over the business, etc. But the key factor is the time taken to recover the proceeds from sales. But the key factor is the payback period: the longer the payback period, the more cash the company will need to finance its operations over the long term.
Working capital at the time of setting up a business
If you are planning to set up a business, it is essential to include working capital requirements in the financing plan when you start up. It will then be covered by permanent capital such as equity, before being covered by any business margins, as should be the case thereafter.
But while WCR can be calculated precisely at a given moment, there is always a degree of uncertainty involved in forecasting it: the extent of supplier debts can vary over time (with inflation in the price of raw materials, for example), and the precise amount of trade receivables outstanding is not yet known. A study of the averages observed within similar companies can therefore provide a good benchmark.
Be careful to take account of amounts including VAT when calculating WCR, as the time lag between VAT collection and payment in turn generates a working capital requirement.
Positive or negative WCR: what are the consequences?
Working capital is an indicator of a company's financial health. An exploding working capital requirement is a sign of poor health that could lead to cash flow problems. It can be calculated periodically (weekly, monthly, quarterly or annually) and its evolution needs to be analysed. Has it deteriorated? If so, do we know why? How can it be improved?
- A positive WCR indicates that the company has more assets (inventories and receivables) than liabilities (debts) in circulation. It therefore needs additional cash and must finance this surplus of assets by other means, such as equity or borrowing. This situation is common in many companies, particularly those with long production cycles or which sell on credit. In addition, an increase in WCR that is not correlated with business growth is a warning sign that should be taken into account.
- A zero WCR means that operating resources are sufficient to cover debts in full. The company has no needs to finance, but it also has no financial surplus.
- A negative WCR is the opposite situationoutstanding liabilities exceed assets. This means that the company is using money from suppliers (via supplier debts) to finance its current operations. A negative WCR is synonymous with available resources for the company. This is good news, and can indicate effective cash flow management, but - a point of caution - it can also signal over-reliance on suppliers for financing, which can be risky.
Multiple implications for the financial management of a company
Managing WCR has direct implications for a number of important areas:
- Cash flow: the lower the WCR, the greater the cash flow generated, with positive margins. The higher the WCR, the more resources the company devotes to financing its business: it has less cash available to meet its short-term financial obligations. Excessive liquidity can put a company at risk of insolvency.
- Profitability: Poorly managed WCR can also affect profitability. Too much stock, for example, means high storage costs and risks of obsolescence. Similarly, large trade receivables can mean that payment times are too long.
- Financing requirements: A positive WCR requires external financing (loans, capital increases), which can increase the company's financing costs and debt levels.
- Supplier relations: A negative WCR implies a high level of dependence on supplier credit, which can influence commercial relations and the company's negotiating power.
Understanding the company's operating cycle is essential to setting the various cursors at the right level and finding a balance, of which the WCR will be one of the main indicators. Good management involves :
- analyse cash cycles,
- optimise stocks,
- ensure an efficient process for collection of trade receivables so as not to increase the natural time lag,
- use cash flow forecasting tools to anticipate working capital requirements and monitor key performance indicators (KPIs),
- identify suitable sources of finance (credit lines, factoring) to cover temporary cash requirements.
5 ways to improve WCR
At any time, a company can seek to improve its financial situation, in particular by using the following levers:
- Reduce customer payment times;
- Set up a system of deposits to be paid by customers to reduce cash requirements;
- Extend payment terms with suppliers;
- Reduce stock rotation times ;
- If the company has a VAT credit, switch to monthly actual VAT to recover it more quickly.
Working capital is a crucial financial indicator that reflects a company's operational health. In addition to the strategies that can be put in place, it is essential to seek to secure the external factors that can impact working capital: for example, by outsourcing debt collection to a specialist organisation to ensure that customer payment deadlines are respected as far as possible, or by reducing the risk of non-payment by carrying out an investigation into the solvency of a potential customer.
Lastly, proactive action is required to ensure that working capital keeps pace with the company's growth.
Finally, good credit management also involves protection against non-payment. With this in mind, there are business credit insurance turnkey solutions or solutions that can be tailored to your needs.
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[1] All the sums owed by a company in respect of social security contributions collected on salaries, but also on the income of self-employed workers. These employee and employer social security contributions are calculated on the basis of the gross remuneration of the workforce.