Why Working Capital is Important
If you think of your business as a car, then working capital is the gas. You might have an excellent car with a top-of-the-line engine, but if you don’t have enough gas, your car won’t go anywhere. Your working capital influences every aspect of your small business, so you must understand the calculation of your cash flow.
As a business owner, once you learn how to calculate your working capital correctly, you’ll understand if you are operating smoothly or need to secure additional resources for your business.
What Does Working Capital Mean?
Working capital is the amount of leftover money once you subtract your current liabilities from your existing assets.
You can use working capital as a financial indicator to tell whether your business is running efficiently enough to continue growing. If your amount of working capital is decreasing, your current business model is not sustainable and drastic changes need to be made ASAP.
On the other hand, if your working capital grows, this allows you to invest in opportunities to expand your business.
How To Calculate Your Working Capital
Although the basic math is simple, several factors go into calculating your working capital. The first step is to add up all of the current assets of your business. Your company's current assets include cash, inventory, property, accounts receivable, unpaid bills, raw material, and liquid assets that you can convert into cash within a year.
The next step is to add up all of the current liabilities of your business. Examples of current liabilities are any amounts of money that your business owes, such as accounts payable, short-term loans, employee wages, rent, taxes, utilities, debts, or any bills to be paid within a year.
From this point, there are two ways of determining your working capital: net working capital or working capital ratio.
Net Working Capital
The easier of the two methods is by discovering your overall net working capital (NWC). You subtract the number of your current liabilities from your existing assets.
For example, if you have $50,000 in total liabilities and $75,000 in current assets, your net working capital is $25,000.
Your goal should be to have more than $25,000 in net working capital for your following business assessment. In the beginning, it’s not uncommon for a new business to have low amounts of net operating money.
The total number isn’t as important as the trend. Having net working capital means you are doing well financially and growing your business safely. If you have less net working capital, you need to reduce your liabilities and increase your assets.
Otherwise, you risk falling into bankruptcy.
Working Capital Ratio
To calculate your working capital ratio, use division instead of subtraction. Take your complete list of current assets and divide it by your current liabilities.
Using the example from earlier: $75,000 of current assets divided by $50,000 of current liabilities yields a working capital ratio of about 1.5:1.
Any positive working capital ratio means that your business is surviving, but the goal is to get that ratio as high as possible. Healthy financial ratios are around 2:1, which means you have enough yearly assets to cover two years of liabilities.
However, some businesses continue operating with only a 1.2:1 ratio. As long as your ratio is above 1:1 and trending upward, you can feel comfortable about the progress of your business.
What Is Working Capital Management?
Now that you can accurately calculate your working capital, you can gauge how efficiently your business is running. If your working capital isn’t where you estimated it should be, you should consider alternative funding sources.
However, you must adopt a new strategy going forward to avoid running into financial troubles again. A more efficient working capital management strategy helps improve your working capital and leads to a healthier business expansion.
Consider these three critical factors when creating an efficient working capital management strategy:
Your business’ inventory is almost like your own special currency. Since no one else has your product, the value is whatever the market determines. The goal of a business is to exchange these products for dollars.
The rate that your business sells and restores the inventory is one of the easiest ways to determine your company’s success. For outside investors, the inventory turnover rate is an essential factor for deciding whether to increase their investment or pull out.
The key is finding the perfect balance between inventory and sales. Having a low inventory means that your business misses out on sales. Having a high inventory means that you are wasting your working capital with unnecessary production.
Any amount of money owed to your business is accounts receivable. These are debts owed by customers, vendors, business partners, or anyone who has done business with your company.
To properly maintain a sufficient amount of working capital, you must collect these funds on time. It’s important to remember that, while accounts receivable make up your current assets, they don’t have as much value as cash on hand. There is a significant difference between someone owing you $10,000 and someone paying you $10,000.
To keep your working capital accurate and avoid financial trouble, make sure you keep your "days sales outstanding" to 45 days or less.
The mirror opposite of accounts receivable accounts payable is the total amount of money your business owes in the upcoming months. Your total amount of accounts payable should always be lower than your total amount of accounts receivable.
If you do not make enough money to cover your business debts, you could quickly end up in bankruptcy. The trick with accounts payable is to try to defer payments as long as you are allowed.
You should always make your payments when you have the money to do so, but you should aim to collect your accounts receivable faster than settling your accounts payable.
Understanding The Working Capital Cycle
As mentioned above, the three key components of working capital are your inventory, accounts receivable, and accounts payable. A typical working capital cycle normally looks like this:
- A business buys the raw material needed to manufacture its product and build its inventory on a line of credit. If the creditors require payment to be made within 120 days, it is known as 120 “payable days.”
- The business manufactures and sells at least the number of finished goods needed to cover the credit. If it takes 85 days to sell the inventory, then the number of days taken to reach this number is called 85 “inventory days.”
- The business receives payment from the customers who buy its products. If it takes 30 days to receive payment, these are referred to as 30 “receivable days.”
By adding your inventory days to your receivable days and subtracting the payable days, you can determine if your working capital cycle is efficient.
For this example, the working capital is 85+30-120 for a total of -5 days.
This means that your business can receive the payments for the sold products a full five days before you must pay your suppliers. Ideally, this number is negative because your accounts receivable is shorter than your accounts payable.
Depending on your type of business, you might not need to have a high level of working capital. Grocery stores and fast-food chains often operate with a negative working capital because they have a high inventory turnover rate.
However, you should aim to have high working capital to ensure that your business stays operational in the event of unforeseen circumstances. If you calculate your working capital and find that it’s insufficient, reach out to Ampla and allow us to help you get back on track.