What is working capital?
7 min read
July 28, 2023 • Block Advisors
Understanding working capital as a small business owner can help you grow your business or take advantage of bigger opportunities. You can use this and other financial ratios to better understand your business’s short-term financial health. Also known as net working capital (NWC), this metric refers to the difference between a company’s current assets (cash, accounts receivable, inventory) and current liabilities (accounts payable, taxes, interest owed, wages) as found on your company’s balance sheet.
In short, calculating NWC will tell you the money you have available to meet your current, short-term goals and obligations.
Importance of Working Capital
Working capital affects several aspects of your business like paying your employees, keeping operations running, and planning for long-term goals. Furthermore, calculating and understanding NWC is important because it measures how efficiently your company is operating. This figure gives insight into your business’s financial health and liquidity. Proper working capital management will help keep your business afloat, avoid cash flow management problems, and see where you may need to borrow money.
How to Calculate Working Capital
To calculate working capital, subtract your company’s current liabilities from its current assets. The NWC formula is:
Net working capital = Current assets – Current liabilities
Let’s calculate working capital for a fictional company called ABC Enterprises. ABC Enterprises has the following current assets and current liabilities:
- Cash and cash equivalents: $100,000
- Accounts receivable: $50,000
- Inventory: $75,000
- Prepaid expenses: $10,000
Total current assets = $100,000 + $50,000 + $75,000 + $10,000 = $235,000
- Accounts payable: $40,000
- Short-term loans: $30,000
- Accrued expenses: $15,000
Total current liabilities = $40,000 + $30,000 + $15,000 = $85,000
So, using the above formula, we can calculate ABC Enterprises’ working capital as such:
Net working capital = $235,000 – $85,000 = $150,000
Therefore, ABC Enterprises’ working capital is $150,000.
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Positive vs Negative Working Capital
The amount of working capital your business has will often depend on the industry you operate in. For example, some industries that have longer production cycles may require higher working capital whereas others, like retail, can raise short-term funds quicker and thus have lower working capital needs.
A business will have positive working capital if it has enough cash, accounts receivable, and other liquid assets to cover its short-term obligations. These obligations could include accounts payable or any short-term debt. On the other hand, if a business has negative working capital, it means that it doesn’t have enough current assets to cover any short-term financial obligations. If your business has a negative working capital, you may have trouble paying suppliers or vendors, raising funds, and growing your business. This is why working capital management is crucial. Keep reading for tips on how to boost your capital.
Working Capital Management
Working capital management is a financial strategy your small business should employ to enhance working capital and meet day-to-day operating expenses. It also helps ensure that your business is using its resources productively. There are three ratios that are used in working capital management that can help you monitor your company’s financial health.
Working capital ratio
The working capital ratio, or current ratio, gives a measure of your company’s ability to meet its short-term obligations. The formula is:
Current ratio = Current assets / Current liabilities
If the ratio is less than one, your company may not have enough cash to pay the obligations of the next year. A ratio between 1.2 and 2.0 means that your company is probably effectively using its current assets. Anything greater than 2.0 means your company might not be using its current assets as efficiently as possible. You could be maintaining a larger than needed amount of short-term assets rather than reinvesting them to spur growth and revenue.
Average collection period ratio
The average collection period (ACP) ratio measures how effectively your company is managing its accounts receivable. The ratio refers to the average number of days it takes to receive payment after a sale on credit. You calculate the ratio over a given period with this formula:
Average collection period = (Average total accounts receivable/ Total net credit sales) x (Number of days in the period)
Inventory turnover ratio
The inventory turnover ratio indicates how effectively your company manages its inventory to meet its demands. It uses the cost of goods sold (COGS) and the inventory’s average value. This ratio indicates how often inventory is sold and restocked over a specified period. It is calculated as such:
Inventory turnover ratio = Cost of goods sold / Average value of the inventory
A higher ratio means your business’s inventory turns over more quickly.
7 Tips for Boosting Net Working Capital
Because working capital is so important, there are strategies and tactics you should be aware of to improve or boost it, increase efficiency, and improve overall earnings.
1. Monitor accounts receivable
Create an accounts receivable aging schedule each month that lists the dollar amounts you’re owed based on the invoice date. You can also automate accounts receivable and payment processing. For example, automating payment processing will keep invoices top of mind for customers and increase the likelihood that they will pay promptly.
2. Speed up the collection process
Working capital shortages can occur when there are delays in payments from clients. The delays will lengthen your cycle which means money is tied up for longer. You should also have a written and enforced policy for collecting money to increase your cash inflow. You may also want to automate overdue notices to accounts with balances more than 30 days old. This can help remind your clients to follow through on their invoices, thus increasing cash flow.
3. Pay vendors on time
Paying vendors on time will help you as a small business owner beyond just maintaining a good relationship with the vendor. Making timely payments helps you avoid late charges and interest. Every little bit counts, and late charges and interest add up fast!
4. Watch for hidden fees
If you are looking to receive funding or outside financing, make sure to look for hidden fees. Lenders will often charge subscription fees or inactivity fees, so make sure you understand the actual cost to avoid high, unexpected fees.
5. Request an up-front deposit
Requesting an up-front deposit allows you to have funds to cover costs for the duration of a project. Deposits also decrease the chance of non-payment.
6. Manage inventory purchases
If inventory is a large part of your cash outflows, be sure to monitor those purchases carefully. Effective inventory management can have a big impact on the overall growth of your business. You want to have enough inventory to meet customer demand, but not so much that your bank account is emptied.
7. Sell illiquid assets
If you’re in a bind and need to increase your working capital, one option is to sell illiquid assets for cash. This increases your current assets which in turn boosts your working capital. However, there are risks involved. If the asset is part of your revenue creation process or may accrue value in the future, you could be undermining future cash flow. Weigh your options carefully before deciding to offload illiquid assets for a quick buck.
Leveraging Working Capital for Your Small Business
Focusing on the most important financial metrics can help you stay organized. Staying on top of your finances is just another part of being a small business owner. Analyzing the different ratios and optimizing your working capital management can improve your business growth.
Sifting through all the financial information about your business can be overwhelming, but it’s an important step to take. Block Advisors can help you with all your small business needs from bookkeeping services and payroll to small business tax preparation. Speak with a Block Advisors small business expert today.