Before you dive in:
Working capital is the difference between a company’s assets and liabilities.
Many use working capital as a metric for the overall health of the business and short-term liquidity.
Positive working capital means the company is able to continue funding its operations for the foreseeable future.
What Is Working Capital?
Working capital offers a way to assess the short-term financial health of a company. It measures the difference between a business’s current assets and liabilities. In other words, this is the money a business has available to cover upcoming expenses.
Working capital measures the liquidity of a business’s ability to meet its short-term obligations.
Short-term liquidity represents a major piece of a business’s financial health.
Understanding Working Capital
Working capital is a straightforward measure of financial health. Here’s a closer look at the components, calculations, and uses.
Calculating Working Capital
As a business owner, calculating your working capital can come in handy. Let’s say that your business’s balance sheet includes the following information:
Current business assets: In total, you have $100,000 in current assets
Current business liabilities: In total, you have $75,000 in current liabilities.
Working capital: When you subtract the current business liabilities from the business assets, you determine the business has working capital of $25,000.
Working Capital Formula
In order to run the numbers for your own business, here’s the formula to use:
Current Assets - Current Liabilities = Working Capital
With this straightforward formula, you can quickly assess the working capital of your business.
Components of Working Capital
The two components of working capital include current assets and current liabilities.
Current assets: Current assets include physical economic resources that your business has access to. Depending on your preferences, you can include all economic benefits the company expects to receive within the next 12 months.
Current asset examples: Any short-term asset that your business has access to canbe included as a current asset. A few examples include inventory, accounts receivable, notes receivable, prepaid expenses, and cash.
Current liabilities: Liabilities include the outstanding debts that your company is expected to pay within the next 12 months.
Current liabilities examples: Any short-term liability that your business is expected to pay is considered a current liability. A few examples include accounts payable, wages payable, taxes, expected debt payments, dividend payables, and unearned revenue.
What Is Working Capital Used For?
Business owners and business managers typically use working capital for meeting short-term obligations and funding their operations.
Short-term expenses: Working capital can be used to cover all of the expenses that keep a business operating. A few of these expenses might include paying employees and covering rent.
Debt payments: If a business has debt payments to keep up with, working capital is usually the source of the funds.
Why Working Capital Is Important?
Working capital is a critical component of running a business. Here’s why positive working capital matters:
Cover necessary expenses: Even if cash flow dips, working capital can be used to stay afloat in the short term.
Stay on good terms with suppliers: Working capital allows you to pay your suppliers on time, even if you see a downturn in business.
- Capitalize on growth opportunities: A little bit of working capital can go a long way if a business opportunity presents itself. The wiggle room created by working capital means you can jump on growth opportunities along the way.
Avoid debt: Debt payments can put pressure on a growing business. In some cases, access to working capital can help you avoid debt.
Advantages of Working Capital
Working capital gives business owners several advantages, including:
Peace of mind: With working capital, your business is ready to weather downturns or cash flow issues.
Flexibility: If you need to switch up your business plan, working capital can make for a smooth transition.
Monitoring working capital helps you avoid surprises: If you stay on top of your working capital, you’ll have a good idea of what financial outlays are coming down the pipeline.
Limitations of Working Capital
Although working capital is a useful metric, it has some limitations:
Focused on the short-term: Working capital is a metric focused on the short-term health of a company. With that, you might miss the long-term outlook.
Constantly changing: As a business operates, working capital can change on a daily basis. By the time you get the information, it might be a tad bit outdated.
Value of assets changes: After you add up a company’s assets, things might change in a matter of minutes:
How Can a Company Improve Its Working Capital?
Depending on the situation, a company can make changes to improve its working capital.
Take On Long-Term Debt
If your company needs an influx of cash, opting for a long-term loan can improve your working capital. After obtaining the loan, your current assets will increase due to the newly available cash. But with a long enough loan term, your short-term liabilities will not increase too much.
Refinance Short-Term Debt
If you have short-term debt, consider refinancing into a long-term loan. Through this option, you are spreading out the cost of the loan. With that, the amount you owe the lender for the next 12 months may be lower than it once was. If appropriate for your business, opt for the longest payment terms available.
Sell Illiquid Assets for Cash
If you have illiquid assets, consider selling them for cash. The influx of cash will increase your current assets and improve your working capital. But only sell assets that your company can continue to thrive without.
In addition to increasing your cash reserves, you can reduce expenses to improve your working capital. A few ways to reduce expenses include eliminating debt, cutting pay on unnecessary purchases, and potentially cutting back on labor costs.
Optimize Inventory Management
An optimized inventory management system will help you order just enough of an item. You don’t want to get stuck with unsellable inventory. If possible, look for ways to reduce overstocking and other superfluous expenses.
Automate Accounts Receivable
Automating accounts receivable processes can speed up how quickly you get paid. After all, business owners are often too busy to continuously follow up with a customer about getting paid. Enlist the help of an automated service to tackle this vital chore for you.
Incentivize Fast Payment
If your customers tend to stretch out to the end of their payment term, consider creating an incentive program for fast payment. For example, you could offer a discount to customers willing to pay for your product or service when it’s delivered.
Why a Company Might Need Additional Working Capital
It’s common for companies to seek more working capital in a variety of situations. Here’s when it might make the most sense:
Growth opportunities: Businesses with sufficient working capital have a better chance of capitalizing on opportunities in the market.
Purchase necessary assets: Some businesses cannot get access to the equipment they need due to a lack of working capital.
Smooth operations: A lack of working capital makes a streamlined business operation difficult to achieve.
Seasonal swings: If your business is very seasonal, you might need more working capital during the off-season to fund operations until the next wave of customers.
Working Capital Mistakes to Avoid
When it comes to working capital, business owners often run into common mistakes. Here’s what to avoid.
Confusing Short-Term Working Capital Needs with Long-Term Requirements
Not every expense your business runs into will be there for the long term. You’ll need to determine what priorities to put in place for your business. For example, you might tighten working capital to pay off your building or stretch out debt terms to give yourself more short-term working capital. Weigh short-term working capital decisions with long-term business costs.
Relying on a Working Capital Line of Credit for All Purchases
It’s tempting to rely on a working capital line of credit for big purchases. But some expenses, like real estate, have specific loans available. Consider reserving a working capital line of credit for short-term financing needs and using specific loans for large purchases.
Paying Unnecessary Fees
If your working capital is tight, you might be pushed into paying unnecessary fees in order to pay for things later. Although this can free up your funds in the short term, it can cost you big time over the life of your business.
Taking On Too Much Debt
When your company is weighed down by too much debt, the monthly payment obligations can put a big strain on your working capital. As a business owner, it’s critical to weigh the costs of taking on debt against a slower growth strategy.
Using Past Revenue to Finance Future Customers
The landscape of your business changes over time. Make sure to reevaluate on a case-by-case basis before financing future customers. Otherwise, you could stretch your working capital thin while waiting for these new customers to pay for your product or service.