The Importance of Working Capital

Posted by Factor Funding Co. on June 21, 2016

 

Working capital is the funds your business has available for day-to-day operations. These expenses can include office materials, maintenance costs, rent, and utilities. This is the money you spend to turn your inventory into monetary revenue. Without working capital, an enterprise will fail—yet many business owners don’t realize its importance. Understanding how working capital affects the health of your business will enable your company to achieve growth and sustainability.

How to Find Your Working Capital

The first step to understanding how working capital affects your business is to assess your current financial situation. You can find your working capital by subtracting your current liabilities from your current assets. Your business’ current accounts payable, expenses, and debts make up your liabilities. Your assets may include accounts receivable, inventory on hand, and cash your business has. Once you subtract your liabilities from your assets, the amount you have left makes up your working capital.

The amount of working capital your business has indicates your financial capacity to pay off short-term debts and daily expenses. If your number is on the higher end, you generally have room for these expenses—meaning you’re most likely handling your company smartly and you have a healthy business. If your working capital number is low or in the negative, you mostly likely don’t have the capacity to afford daily expenses and should probably rethink your commercial model.

You can also find working capital using a ratio. The working capital ratio is your current assets divided by your current liabilities. Use the same two numbers as you would in the first equation, but divide the two instead of subtracting. If the number you get is less than 1.0, it means your liabilities exceed your assets and you have negative working capital (a sign of an unhealthy business). However, if your number is too high, it can be a sign that you have too much inventory or extra assets on hand.

Your “ideal” working capital number will vary depending on the industry, but as a general guideline, you can assume numbers between 1.2 and 2.0 are healthy. Once you have an idea of what your working capital looks like, you can get a handle on your company’s financial health. You can take steps to remedy a potentially bad financial situation or continue to run your healthy business with confidence.

Working Capital Management and You

Working capital affects your company’s ability to borrow funds, increase shares, and pay short-term debts and expenses. It’s a measure of your company’s liquidity and of your creditworthiness. Loan and investment companies may look at your working capital to decide if you’re a good applicant for a loan. While your working capital is no guarantee that you have a healthy business, it can give you important financial insights.

Understanding and managing working capital is remarkably important to the overall financial health of your business. Without working capital management, you could be at risk of bankruptcy and not know it. Proper management of day-to-day expenditures can help you avoid bankruptcy and understand your business’ long-term needs. Striking the ideal balance between assets and liabilities can help your enterprise manage minor operations and absorb large losses.

Small businesses must assess their working capital to grow and evolve with financial stability. Working capital management involves managing your company’s daily, weekly, and monthly cash flow to satisfy your debts and keep enough capital to continue a healthy operation. Start-ups must pay attention to working capital to discover if they’re going into the negative, breaking even, or making a profit.

Managing your working capital helps you assess your business’ long-term health. Working capital numbers or ratios reveal problems within your operations and allow you to make changes to avoid bankruptcy. You can reduce your current liabilities by adjusting your short-term debt into long-term debt or by factoring your accounts receivable to get your company back on track.

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