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When discussing corporate cash flow, the tech and retail industries are often used as opposing examples of how different business types use working capital. In general, retail businesses require much more working capital than tech companies, largely because of their inventory needs. The rate at which each business type earns and then spends money, and how and when it must fund regular expenses, contribute to determining its working capital needs.
Key Takeaways
- Working capital is the cash or cash equivalents that a company has for everyday expenses. It’s calculated by subtracting current liabilities from current assets.
- Retail businesses typically need higher working capital due to their long operating cycles, especially during peak seasons. They must purchase significant inventory in advance and manage expenses while awaiting sales income.
- Tech companies, particularly software firms, often have lower working capital needs because they don’t need to maintain physical inventory. Software can be sold digitally, reducing upfront costs significantly.
- While software companies can operate with minimal working capital, tech companies that deal with hardware have substantial inventory needs similar to retail businesses. They also require investments in materials and equipment.
- Working capital needs can fluctuate throughout the year due to varying sales and inventory demands, highlighted by holiday seasons in retail and differing operational costs across tech sectors.
What Is Working Capital?
Working capital is simply the amount of cash or cash equivalents a company has on hand for day-to-day expenses. It can be calculated easily by subtracting a company’s current liabilities from its current assets. Current assets are anything the company owns that can be used to pay expenses quickly. These include cash and similar accounts, marketable securities, and accounts receivable. Current liabilities include those debts and expenses that the company must fund within the current rolling 12-month period.
How Retail Businesses Manage Their Working Capital
The amount of working capital that each type of business requires is largely dictated by its operating cycle. The operating cycle is expressed as the number of days that elapse between when the company spends money on inventory and when it receives income from the sale of that inventory. That income is then used to purchase more inventory, continuing the cycle. Retail businesses often have long cycles because they must purchase large amounts of inventory well in advance of any sales. This is especially true of brick-and-mortar retail operations because huge amounts of inventory are often necessary just to open a store. Because retail stores rarely sell all their inventory right away, they must maintain higher levels of working capital to ensure that they can meet any short-term expenses without relying on income from sales that may not come until much later.
The need for ample working capital is especially heavy in gift-giving holiday seasons. Retail stores must prepare early for the onslaught of holiday shoppers, which means outlaying huge amounts of capital for inventory in advance. The income from those sales may be months away, so retail businesses must ensure that they have more than enough on hand to cover bills, rent, insurance premiums, loan interest, wages, and other short-term expenses without relying on future income. This means retail businesses actually need even more working capital just before and during peak holiday shopping season than they do the rest of the year.
Managing Working Capital in the Tech Industry
The amount of working capital a business needs fluctuates throughout the year, as evidenced in the above example about holiday retail trends. Many tech companies do not rely on physical products to fuel sales, meaning their working capital needs are much lower. However, there is an important distinction between software companies and hardware companies.
A tech company that only sells software through a website has little need for working capital. Since there is no physical product to keep in stock, and software can be downloaded by customers at the click of a button, there is no need to worry about up-front inventory expenses. Software companies can, therefore, typically get by with very low, or even negative, working capital since they have very low upkeep costs and no inventory costs. If the company is entirely online with no brick-and-mortar locations, this is even truer. Once the website is set up and the domain name obtained, websites cost very little to maintain. Even if a small online software company makes no sales for months, it would likely be able to remain operational with minimal working capital. This becomes less true as the size of the business grows, of course, as working capital may be needed to pay salaries and other recurring expenses if sales remain low.
Companies that manufacture and sell hardware, such as computers, phones and their component parts, have a lot more inventory to deal with. They, therefore, have working capital needs that are much the same as a retail business. In addition to finished products for sale, however, these businesses must also stock the raw materials needed in manufacturing, which ties up working capital longer. Any type of manufacturing business typically requires a lot of up-front investments in machinery and equipment, so tech companies that both develop and manufacture hardware products must also maintain high working capital to ensure that loan payments can be kept up even when sales are down.
