We all know that a business needs money to operate. But how do you figure out exactly how much you need? The answer lies in working capital.
Working capital is a measure of how well you are able to cover your operating expenses through current assets. It includes all money in the bank, accounts receivable and inventory, minus short-term debt. If you have more working capital than necessary, you can use it for investments or other purposes. If you have less working capital than necessary, however, then your business may not survive for long.
In this article, we'll discuss what working capital is, how it impacts your business and we'll show you how to calculate your own company's working capital.
What is working capital?
Working capital is the difference between a company's current assets and current liabilities. It is also known as "net working capital," "working capital surplus/deficit," or simply "free cash flow."
Working capital is an important measure of liquidity, or how easily a business can pay its immediate bills. It’s usually calculated quarterly and represents the amount of cash available to finance operations, pay off debts and fund other expenditures.
The most common types of current assets include:
- accounts receivable
Examples of current obligations or liabilities include:
- accounts payable
- accrued expenses
- and short-term debt
When calculating working capital requirements, one may determine that it's necessary to raise additional funds in order to run the business while also paying off lingering debts (i.e., if you have more liabilities than liquid assets).
Why working capital matters
The first question you might ask yourself is, “Why does working capital matter?” The answer is simple: It's the money a company has at its disposal to invest in growth.
Working capital is an important measure of a company's strength, and it can be used to help make business decisions.
Here are some ways you can use working capital:
- Assess the financial health of your company. If you have a negative net working capital, that means you're losing money and may not be able to pay back any loans.
- Determine whether or not your business needs more cash for growth. If you have positive net working capital and need additional funds for expansion, you may want to consider asking investors for investment dollars or taking on debt by borrowing from banks or other lenders.
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Why working capital management is so important
Working capital management is important for your business because it gives you a glimpse into how well you’re managing your debt, making payroll, earning revenue and dealing with inventory.
Good capital management is an indication of your company’s:
- Financial well-being: Working capital is one of the most important financial indicators you can use to tell if your company is growing and running smoothly.
- Daily operations: Working capital helps you understand how well your organization is functioning on a day-to-day basis and ensures that you have enough cash on hand to pay employees, suppliers, and creditors.
- Efficiency: The better you manage your working capital, the more efficient your organization becomes overall. The less wasted money there is in processes and systems within the business—and the less cash flow problems—the more efficiently everything runs.
- Liquidity: Working capital management can also help you avoid cash flow problems that could place your business in a financially risky situation.
How to calculate working capital
Working capital is an important indicator of your company’s overall financial health because it shows how much money you have available for growth and expansion. To calculate your company’s current working capital ratio, you’ll need to subtract current assets by current liabilities.
Working Capital = Current Assets - Current Liabilities
Current assets such as cash in business accounts, accounts receivable and inventory that you anticipate will be converted to cash within 12 months.
Current liabilities include accounts payable, employee salaries, taxes and money owed to creditors.
Why you may need additional working capital
When you’re growing your business, it’s important to be prepared for the unexpected. Additional working capital can help you plan ahead and cover any gaps in your business’s cash flow.
Additional working capital may mean you’ve had a period of good revenue, but most business owners know lean months are a reality as well. You may want to put some available capital aside to cover any shortfalls or unexpected cash flow problems in the future. Positive net working capital can also help cover gaps in receivables when customers are late on paying you.
You may want to set aside funds to cover anticipated tax bills or build up an emergency fund for unexpected costs.
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