Your business is making money, you’re gaining more customers, and enjoying a steady stream of incoming cash. Perhaps you’re considering growing your team of employees, expanding your inventory, services, or product offerings, or taking additional steps to solidify your business’ impact on the market.
But even with a consistent cash flow, your company needs to understand that working capital can serve as the crucial buffer zone that keeps your business afloat if things take an unexpected downturn. If the gap between the money you’re bringing in and your expenses is narrow, something as simple as an invoice that’s never paid can potentially spell disaster.
Read on to find out more about calculating your business’ working capital, and how to secure additional working capital so that you can grow to scale and ensure that your business is resilient in the face of economic and market fluctuations.
What is working capital?
Simply put, working capital is a financial metric which refers to the amount of funds you have at any given moment. It is a critical indicator of a company’s financial health and creditworthiness. Typically, these are the funds that you can use for your business’ day-to-day functioning and growth efforts. It is also a crucial metric for evaluating the short term financial health of an organization. An alternative working capital definition would be your easily accessible money for paying rent, buying more inventory, and compensating your employees. The term “positive working capital” means that your business has sufficient funds to pay vendors, suppliers, and other financial obligations, as well as continue growing to scale.
How to calculate working capital
You can calculate working capital by taking the sum of your company’s assets and subtracting its liabilities. These figures are extracted from the company’s balance sheet. Your business’ current assets include cash made from the sale of goods or services you provide, equipment, inventory, and accounts receivable (future payments from customers). The term assets and current liabilities describes money that your business owes, such as interest on loans, taxes, employee wages, and accounts payable (money owed to vendors and suppliers). The formula for calculating your working capital is as follows:
Current assets – Current liabilities = Working capital.
For example, if your assets are worth $100,000, and your liabilities are worth $25,000, then your business would have $75,000 in working capital. One of the most challenging aspects of calculating your business’ working capital is that due to market fluctuations and a volatile economy, both your liabilities and assets may fluctuate from month-to-month.
What is a working capital ratio?
To calculate working capital ratio, you need to understand the proportion of assets to liabilities within your company. A company with $200,000 in assets and $100,000 in liabilities would have a 2:1 working capital ratio. A working capital ratio of 1.5 to 2 is considered healthy and indicative of a business being in solid financial standing, but a working capital ratio of less than 1.2 may mean that a company will face liquidity challenges in the future.
Why working capital matters
If you have a steady cash flow, but also an equally steady string of high expenses, you won’t have much flexibility in case the unexpected happens. A company’s ability to meet its financial obligations and manage short-term liabilities is reflected in its net working capital. For example, if the market suddenly takes a downturn, you lose a major client, or one of your supplies abruptly spikes in price, your business will struggle to have access to enough capital to weather the bumpy period.
A large amount of working capital gives you wiggle room to keep your business running smoothly during tougher periods. If your working capital ratio is low, meaning that your assets are close in value to your liabilities, something like a customer failing to pay an invoice on time could potentially disrupt your ability to pay your business’ bills.
Negative working capital, where current liabilities surpass current assets, can signal potential financial distress and cash flow issues, though it may not always be detrimental if the company can generate cash quickly.
Working capital vs. net working capital
In general, working capital and net working capital are often used interchangeably to the same thing – the amount of money that your business has access to, which is calculated by subtracting your liabilities from your assets. But some financial experts do consider net working capital to be a different metric than working capital.
Net working capital can be defined as your current assets (not including cash) – current liabilities (not including debt). Other formulas for defining net working capital as accounts receivable + inventory – accounts payable. If you’re speaking about your company’s short or medium term liquidity, you should use the term working capital. However, in conversations about your business’ long term liquidity, you may use the metric of net working capital.
Working capital management
“Working capital is like your diet; if you do not manage it, then it can kill you,” says Dan Corredor, President at The Strategic CFO. While funny, Corredor’s statement certainly rings true. Operational efficiency, which involves effectively managing working capital, is crucial for financial management and business performance.
Managing your capital correctly can be the make-or-break factor between a strong business and one that struggles to withstand ups-and-downs in the market. Ensuring that your working capital ratio is strong and that your business has sufficient working capital on hand to withstand economic fluctuations and unexpected complications is critical for securing your business’ future.
Effective working capital management helps instill resiliency in your business model and operations, as well as a sense of much-needed stability in the face of a turbulent, unpredictable market. There are several critical aspects to working capital management, which involve monitoring, analyzing and strengthening your business’:
- Working capital ratio. This means ensuring that the gap between your business’ assets and liabilities is wide enough that you’ll have cash on hand, even in the face of unexpected developments.
- Collection Ratio (Days Sales Outstanding). This metric gauges whether your company is handling accounts receivable in the most beneficial way for your business. You need to be sure that you are collecting on invoices in a timely manner, so that your business can continue operating smoothly and is being appropriately compensated for the goods and services that it provides.
- Inventory Turnover Ratio. This is the art of ensuring that you have enough inventory on hand to satisfy customer needs, but not so much inventory that you’re backed up and spending money on products that aren’t moving.
If your working capital ratio, collection ratio, and inventory turnover ratio are all strong, your business has the right pattern of spending on liabilities and profiting from your assets to keep your organization liquid.
What is a small business line of credit?
Similarly to a business credit card, a business line of credit is funding provided by a financial institution that allows a small business to borrow money, up until a specific set maximum limit. A small business line of credit can help you boost your working capital, so that you have access to the funds that you need in order to perform actions that can strengthen and grow your business.
How to improve your working capital
A small business line of credit can serve as a valuable resource to expand your available working capital. Understanding the working capital formula is crucial for assessing your company’s financial health and liquidity. Cash or inventory secured via your line of credit is counted among your assets, but the monthly interest spent on paying back the funding you’ve borrowed should be counted as a liability. Increasing your cash flow is a classic way to grow your working capital.
Consider streamlining your operating cycle, and taking steps to convert money earned by your business into cash as quickly as possible. That could look like offering your clients shorter billing cycles or requiring upfront or immediate payment for your products or services.
Slashing your expenses and reducing liabilities are also effective steps towards boosting your working capital. Review your liabilities and see if there are any areas where you can cut back. For example, if you’re able to reduce unnecessary spending, you can see an instant improvement in your working capital ratio. Working capital is a valuable tool for your company to withstand bumps in the road and keep operating, even if circumstances are challenging.
By working to be sure that your small business maintains a strong working capital ratio, you’re giving yourself peace of mind and a buffer for surviving unpaid invoices, market crashes, and other disruptions.
