The Ins and Outs of Working Capital
When you own a business, the money that you use for your everyday operations is your working capital.
This is an item that potential investors can determine from your financials. Working capital is your current assets less your current liabilities.
Let’s say that your balance sheet right now lists that you have $200,000 in cash, $20,000 in accounts receivable, as well as $80,000 in inventory on hand. That gives you $300,000 in current assets. On the other side of the sheet you have $10,000 in notes payable, $25,000 in accrued expenses and $75,000 in accounts payable. Your current liabilities total $110,000.
So your working capital is $300,000 – $110,000, or $190,000.
Why is this important to you?
As a business owner, your working capital tells investors how efficient your company is, and how much liquidity you have. Some of the metrics involve include what you owe, what people owe you, and what you have on your shelves and in your bank account, so it is a snapshot of several different types of company activities, including how you manage your inventory, collect revenue, pay your bills with suppliers and manage debt, if any.
If your working capital is positive, that means that you can generally pay your short-term liabilities off almost right away. If you have negative working capital, though, it means that you’re juggling those liabilities. So if working capital decreases, investment analysts will say that a company’s leverage is losing balance, can’t collect receivables in a timely manner or is having a hard time keeping sales level (or growing them). If your company’s working capital is increasing, that means that you’re not having any of those problems.
There are several different ways to provide a more detailed analysis of a company’s working capital, such as the receivables ratio, current ratio, quick ratio, days payable and the inventory-turnover ratio.
What should small business owners know about working capital?
One of the biggest drains on working capital is inventory. Yes, it counts as a current asset, but if it’s just sitting on your shelf, or if it’s taking up space in your warehouse, it’s tying up your liquidity. You had to pay for it, and you don’t get any money from it until it goes out the door.
If you don’t manage your inventory and other expenses carefully, you can end up with a warehouse full of things to sell but no cash, because you tried to expand and invested in more inventory. This happens most frequently when companies pay for everything with cash instead of taking out financing that would have made a more flexible payment schedule and left more cash on hand for other uses. This is why working capital shortages are fatal to a number of small businesses even when those businesses are bringing in a profit. Managing financing and cash is crucial to maintaining the efficiency of a company.
This is why level and timing are more important with cash flow than the amount of revenue. The working capital formula makes the assumption that a company would liquidate everything in its current assets to satisfy current liabilities, which is not always a realistic answer, because you always need cash to pay your staff and keep the lights on. The working capital formula also makes the assumption that you can call in accounts receivable immediately – which all business owners know is not true.
One more factor is that the way a company times asset purchases, sets policies for payments and collections, writes off some receivables that are past due and raises capital for ongoing and future operations can work out differently for companies. Different industries have different working capital needs; you’re going to need a lot more heavy machinery if you’re opening a road construction business than if you’re selling Star Wars merchandise. Finding the best ways to keep your cash payments consistent so that your working capital remains relatively stable can be difficult if your business requires a lot of investment up front. So if you’re an investor, rather than a business owner, it’s important to educate yourself on how the requirements of different industries influence a company’s ability to maintain different levels of working capital.