What is Working Capital and Why is it Important?
You may have heard the term ‘working capital’ before, but are you familiar with what it really means? Working capital refers to the ability of a business to pay off current liabilities using current assets. Working capital is a key component in the success of a company and can affect several parts of the business, such as long-term growth and funding inventory.
To ensure your company has adequate working capital, you need to first understand what working capital really is and how to calculate it.
Working Capital Explained
Working capital measures the difference between your company’s current assets and current liabilities. Essentially, it tells you what your business owns versus what your business owes. To understand working capital, you need to first understand the components that go into calculating it.
Current assets are the tangible and intangible assets that can be liquidated for cash. These assets can include things like accounts receivable, checking & savings accounts, mutual funds, and stocks & bonds.
Current liabilities refer to the debt or expenses that your company owes. These can include taxes, rent, accounts payable, salaries, and even utilities.
How to Calculate Working Capital
Working capital can be calculated with the formula current assets – current liabilities. It measures your company’s ability to pay off short-term debts.
You can also determine working capital using the current ratio, which is current assets / current liabilities. For the current ratio, your goal is to be at or above your industry’s average. However, an extraordinarily high current ratio can indicate that you are managing your assets irresponsibly.
How to Increase your Working Capital
Improving your working capital is essential to ensure your daily operations are running smoothly. Whether you want to apply for a performance bond or cover short-term debt, having positive working capital is crucial. Here are some tips to increase your company’s working capital.
- Increase accounts receivable. Give customers a motivation to pay on time by offering incentives.
- Capitalize on tax incentives. Redirect money towards capital funds by taking advantage of tax incentives.
- Avoid back stocking. Avoid having extraneous inventory by using just-in-time stocking methods.
- Get loans on working capital. Take out loans if necessary to fund your short-term operational needs if necessary.
- Cut unnecessary expenses. Determine any unnecessary expenses your company has incurred and cut them for the time being.
Current assets are tangible and intangible goods a company owns that can be turned into cash. This includes checking and savings accounts, accounts receivable, inventory, bonds, mutual funds, and stocks.
Current liabilities are any debts and expenses the company has incurred within a year (or one business cycle). This includes everything from rent, utilities, and supplies to accounts payable, accrued income taxes, salaries, and dividends payable.
When a company’s current assets exceed current liabilities, they have positive working capital. If a company has considerable positive working capital, then it has the potential to grow. When a company has the same amount of current assets and current liabilities, it is referred to as zero working capital. This is most prominent in demand-based organizations, where there is little to no inventory.
If you find yourself short of cash, cash flow can be increased in a few ways:
- Improve accounts receivable: Encourage customers to pay on time by offering incentives.
- Pay debt on time: Avoid unnecessary penalties and use electronic payment systems to ensure all debt obligations are met on time.
- Take advantage of tax incentives: Tax incentives save money that can be used for working capital funds.
- Cut unnecessary expenses: Audit your monthly expenses and break it down into components. Is everything you’re paying for necessary? Trim the fat and focus on expenses that maintain company functionality.
- Avoid stockpiling: Manage your inventory so that every item is sold and products arrive exactly when you need them. When inventory is quickly converted to cash, less capital is tied up in unused assets.
- Working capital loans: If needed, working capital loans are available to fund short-term operational needs.