What is business working capital and why is it important?
Tue | July 2022
By staying on top of your business capital needs, you’re taking a vital step to care for your company’s financial health. Having enough working capital and circulating it at the right time can help your business in times of stagnation and growth. Use this guide to get a clear picture of how much working capital you’ll need to manage your business success this year.
What is working capital?
According to Investopedia, working capital is the difference between your business’s current assets—including accounts receivables, customers’ unpaid bills, cash, and raw material and finished good inventory- and its current liabilities, including accounts payable and debts.
It’s also a great indicator of your liquidity and financial health. Something relevant in decision making, long-term business plans, and making a great impression on potential investors or financial institutions.
How to calculate working capital
Working capital is calculated from a company's balance sheet's current assets and current liabilities. A balance sheet is one of three primary financial statements produced by businesses, the other two being an income statement and a cash flow statement. Below you'll find two easy-to-implement formulas you can use to get a solid idea of how much cash you have available to meet your business needs.
Formula to calculate working capital:
Working capital = Current assets – Current liabilities
Working capital example:
Let's say you own a furniture store and want to know how much capital you have available for the rest of the year. Plug those numbers in, and that's how much net working capital you'll have at your disposal. Is it enough to meet your current needs?
If we put our common sense to use, we know that positive results indicate that your business is ready to tackle future operations and growth. But beware! If this number is too high, you might be accumulating customer debt, or your sales could be at an all-time low. Your working capital needs to circulate!
There're other financial ratios used for working capital management; the working capital ratio is a way to measure a company's ability to meet short-term financial obligations.
Working capital ratio = Current assets / Current liabilities.
Working capital ratio example:
Now, same furniture store, but let's say you want to find out how many times you can pay off your current liabilities with your existing assets. So, let's start. If the sum of your current assets is $500,000 and your current liabilities cost you $25,000 that would give you $500,000 / $250,000 . In other words, a 2:1 ratio.
It depends on your industry, but a ratio below one could be a red flag for liquidity problems. On the other hand, the above two ratios could indicate that you're not working to your fullest to generate maximum revenue. The ideal number? A right-in-between ratio of 1.5.
Remember, think short-term. Only include assets and liabilities for the next 12 months. For example, in current assets, you could consist of the cash in your business bank account, bills customers will have to pay you back, or sold inventory. For liabilities, you could sum up your employee salaries, taxes, or debts to vendors for the year.
For helpful accounting formulas to measure your business income, read How to create a profit and loss statement for small businesses.
Understanding your business needs
There’s no one-size-fits-all formula to understanding how much working capital your business needs. But you can use three leading indicators to understand your business needs: your type of industry, seasonal differences, its operating cycle, and your management objectives.
Type of industry or business: Some industries require more significant and anticipated working capital than others. For example, the retail and manufacturing industry needs enough cash to bulk up on pre-made inventory, raw materials, and goods. On the other hand, if you’re providing online services, you might only need working capital to gain enough exposure or visibility.Tax liabilities are also short-term expenses you should be on the lookout for.
Seasonal differences: If your business peaks during specific seasons, it could be seasonal. You’ll need to bulk up on capital to get the best of that moment. On the other hand, maybe you need an extra cushion to keep it operating during low-demand stagnant times. Figure out where your business stands and think ahead of the game.
Operating cycle: How long does it take to create and sell your product or services? Are customers paying your bills on time? Ask yourself these two questions to determine if you have a long or short operating cycle and enough money to cover your current liabilities. If your business depends on account receivables, or in other words, that the customers you bill payments on time, then you might need to boost your working capital needs beforehand.
Management objectives: Consider writing and re-visiting your business objectives every quarter to ensure you have enough working capital to fulfill them. Are you a new business that hasn’t consolidated constant revenue flow? Maybe you’re planning on expanding your product or services abroad and need to invest in research and logistics? Take the reins and manage your working capital needs based on your objectives.
Consider your business needs but always keep your assets as liquid as possible. This means having enough cash available to meet obligations, operate your business smoothly, and take advantage of opportunities that may present themselves. If you need faster access to working capital than you can produce by realigning your business processes, it could be time to look for outside funding.
Finding an option to boost your working capital
Over time, a shortage can cause even a profitable business to fail. Thankfully, business funding options can help you quickly meet working capital needs. No, we’re not talking about bank loans. Our business funding focus on the health of your business not just your personal credit score. They also do not require you to go through a complex application process.
We work to help small and mid-sized business owners get access to working capital with an easy, straightforward online process. Get started now!