We have all heard the term “working capital”, but what is it exactly? How can you best utilize it for your small business?
Working capital refers to the short-term financial health of a business to fund its day-to-day operations, including recurrent expenses and paying short-term debts. It is a financial metric or a formula that represents the liquidity of a business.
To have a solid foundation about working capital, here are some key facts:
- Working capital is a verb, not a noun.
- Working capital is measured in days.
- Working capital is a business cycle.
Knowing the working capital for your business can help you avoid situations where you cannot meet short term financial obligations due to delayed payments or slow-moving stock. Without working capital, your business cannot survive so this little overview is worth paying close attention to!
How to Calculate Working Capital
The amount of working capital is calculated by getting the difference between your current assets and current liabilities.
Working Capital = Current Assets – Current Liabilities
Typical current assets include cash, accounts receivable, inventory, and short-term investments.
Typical current liabilities include accounts payable, accrued expenses and taxes, customer deposits, and other trade debt.
When business owners know their working capital, they also understand their liquidity, which helps in making accurate assumptions and precise decisions regarding the efficiency and financial stability of your business. Investors also focus on your working capital to assess not only your company’s short-term financial health, but also its liquidity.
What’s the Importance of Working Capital for your Business?
Since you already know what working capital is and how to calculate it, you can optimize it to keep your business moving without a hitch. Below are some of the top reasons why working capital is important for your business.
Funds tied up in working capital tend to earn little, or no, return. Hence, if your company has a high level of working capital, you may fail to achieve the return on capital employed (ROCE) expected by its investors, which is calculated as below.
Operating profit ÷ (Total Equity and Long-term Liabilities).
If your business operates with lower working capital you will post a higher ROCE. As such, shareholders will receive higher profits for their investments. When stockholders and bondholders invests in your business, the ROCE helps them to know the extent to which your business turns capital into profits.
Liquidity refers to the extent to which a business can convert its assets into cash without affecting their marked price. Sufficient working capital enables a company to accomplish its short-term obligations. When you have more cash tied in working capital, it means that your business has additional liquidity that discourages external financing. Small businesses can benefit from higher liquidity, which result from improved cash management.
Increase in the Value of Business
When you have an effective working capital management for your business, you should rest assured that your company will increase in value due to increased cash flow. As the firm heavily invests in short-term resources, its working capital eventually increases because it has to carry out its routine tasks using large cash. Therefore, the value of a business would increase because the cash represents a certain measure of working capital.
If a business does not have sufficient working capital to carry out its daily operations, it could lead to financial insolvency, which takes account of bankruptcy, asset liquidation, and endless lawsuits. However, with an effective strategy to manage working capital, you can improve the solvency of your business as a prerequisite to meet short-term obligations and various operating costs.
Working capital can help your business gain competitive advantage over rival firms and achieve sustainable growth. If your company has a productive working relationship with other business owners and suppliers, it means debtors are paid on time, which leads to favourable financing agreements including discounts from trade partners. Therefore, you should manage your balance sheet as tightly as you manage your income statement. Working capital is a good first step in managing your balance sheet, and if done correctly, it can become one of the most significant competitive advantages for your business.
Uninterrupted Production Process
Great business relationships with partners, suppliers, contractors and customers should never be underestimated. A business that has enough working capital to pay its suppliers promptly would enjoy uninterrupted flow of factors of production. Making upfront payments to suppliers generally improves business relationships and provides the advantage to negotiate better terms. As such, all customers will be able to purchase and receive their products promptly. Furthermore, if you have a resourceful working capital management, you can increase the production capacity of certain products when demand increases unexpectedly.
Happy Employees, Happy Customers
Any good business owner must acknowledge that to keep current employees and customers at their best, you have to use some of that working capital to invest in people and grow your team. Not only will it prevent employees from being overworked (which leads to resentments, fatal operational mistakes, and resignations), but also keeps them happy and motivated. This will ensure that you are able to stay on top of the growing demands of your business, thus keeping your customers happy, as well.
Have the abovementioned ways to use working capital paid off? Managing working capital is synonymous with efficiently managing other resources in your business. Other financial indices including the turnover ratios, the collection ratios, and key performance ratios can only be effectively achieved by having an efficient working capital management.
In order to know the amount of working capital that your business can effectively use to run its operations, Tianlong Services has ingenious and accurate ways to help you calculate the same. Our business improvement professionals have the knack to determine the approximate amount of working capital that your business needs to settle its short-term debts.