What is working capital?

Working capital symbolizes the lifeblood of any healthy company. Many profitable businesses have, over the years, found themselves insolvent in spite of healthy profitability and significant assets. The issue here has been because of a lack of working capital, without which no business can survive. This article will explain working capital in-depth and its crucial place in the business life cycle.

Working capital definition?

You can think of capital as another word for money and working capital as the money available to finance a businesses’ day-to-day operations – essentially, what you have to operate with. From a financial perspective, working capital is the difference between current liabilities and current assets. Typically, ‘current assets’ is the money you have in the bank and any assets you can quickly convert to cash if you require it. Current liabilities are debts that you need to repay within the year. So, working capital is what is justify over when you deduct your current liabilities from the money you have in the bank. Working capital is also a measure of a business’s financial health. The bigger the difference between what you own and what you owe short-term, the healthier the company. Not unless, of course, what you owe far exceeds what you own. In that case, you have negative working capital and are close to being out of business.

Additional comments on working capital

The adequacy of a business’s working capital is based on the industry in which it competes, its relationship with its suppliers and clients, and other factors:

  • The kinds of current assets and how faster they can be converted to cash. For example, marketable securities can be converted to cash faster than inventory.
  • How clients pay and the nature of the company’s sales: If a company has very consistent sales through the Internet and its clients pay with credit cards during the time they place an order, a small amount of working capital may be enough. Nonetheless, another business in an industry where the credit terms are net sixty days will require a greater amount of working capital.
  • Having an accepted credit line with no borrowing enables a business to operate comfortably with small working capital.

In simple terms, there is more to working capital than simply deducting current liabilities from current assets.

Calculating working capital

You can identify where you stand right now by determining your working capital ratio, a measurement of your business’s short-term financial health.

Working capital formula:

Current assets divided by Current liabilities (equals) Working capital ratio. For instance, if you have current liabilities of $500,000 and current assets of $1 million, your working capital ratio is 2:1. Generally, this would be considered a healthy ratio; however, in some industries or types of businesses, a ratio as small as 1.2:1 might be adequate. Your networking capital tells you how much money you have readily available to meet current expenses.

Net Working capital formula:

Current assets (deduct) Current liabilities (Equals) Net working capital. For these calculations, contemplate only short-term assets like the cash in the accounts receivable and your business account — the money your clients owe you — and the inventory you expect to convert to cash within twelve months. Short-term liabilities include accounts payable — money you owe vendors and other creditors — and other debts and accrued expenses for salary, taxes, and other outlays.

Does working capital change?

Whereas working capital funds do not expire, the working capital figure changes over time. That is because a company’s current assets and current liabilities are based on a rolling 12-month duration. The exact working capital figure can change on a daily basis, based on the nature of a business’s debt. What was once a long-term liability, as a 10-year loan, now becomes a current liability in the ninth year after the repayment deadline is less than a year away. Likewise, what was once a long-term asset, like equipment or real estate, suddenly becomes a current asset after a buyer is lined up.

Working capital as a current asset cannot be decreased in value the way long-term, fixed assets are. Like accounts receivable and inventory, specific working capital might lose value or even be written off sometimes; however, how that is recorded does not follow depreciation guidelines. Working capital as a current asset can only be charged instantly as one-time costs to match the revenue they assist in generating in the period.

Whereas it can not lose its value to depreciation over time, working capital might be depreciated when certain assets have to be marked to market. This occurs when an asset’s price is lower than its initial cost, and others are not salvageable. Two common examples involve accounts receivable and inventory. Inventory obsolescence can be a real problem in operations. If that happens, the inventory market has priced it lower than the inventory’s original purchase value, as noted in the accounting books. To depict current market conditions and use the lower cost and market approach, a business marks the inventory down, leading to a loss of working capital value. Typically, some accounts receivable might become uncollectible at some point and have to be completely written off, which is another depreciation in working capital. As such losses in current assets lessen working capital below its desired level, it may take longer-term funds or assets to replenish the current-asset shortfall, a costly way to finance additional working capital.

Understanding your business needs

To understand your working capital needs might involve plotting month-by-month outflows and inflows for your company. For example, a landscaping company might find that its revenues spike in the spring, then the cash flow is comparatively steady through October before dropping almost to zero in winter and late fall. On the other side of the books, the company might have many expenses that continue throughout the year.

Sections of these calculations could include making educated guesses about the future. While historical results can guide you, you will also need to factor in the possible loss of important customers or new contracts you expect to sign. It can be challenging to make correct predictions if your business is growing rapidly. These projections can help you identify months when you have more money going out than coming in and when that cash flow gap is widest.

Reasons why your company might require additional working capital

  • Almost all companies will have times when additional working capital is required to fund obligations to employees, suppliers, and the government while waiting for payments from clients.
  • Seasonal differences in cash flow are typical of many companies, which might require extra capital to keep the business operating or gear for a busy season when there is less money coming in.
  • Additional working capital can be useful in improving your business in other ways, for instance: allowing you to make excessive use of supplier discounts by buying in bulk.
  • Working capital can also be used to cover project-related expenses or pay temporary employees.

Finding options to increase your working capital

An unsecured, revolving line of credit is an effective tool for boosting your working capital. Lines of credit are created to fund temporary working capital needs. The terms are more suitable than those for business credit cards, and your company can draw only what it requires when needed. Whereas a business credit card can be a convenient way for you and top staff to cover incidental expenses for entertainment, travel, and other needs, it is usually not the best option for working capital purposes. Limitations include higher interest rates, the ease of running up excessive debt, and higher fees for cash advances. 

How to qualify for a working capital line of credit?

When a business owner applies a line of credit, lending institutions will consider your balance sheet’s overall health, including your networking capital, working capital ratio, annual revenue, and other factors.  Since small business owners’ business and personal finances tend to be closely linked, lenders will also evaluate your tax returns, credit scores, and personal financial statements. You’ll have to provide a personal guarantee of repayment. Even though many factors might affect the size of your working capital line of credit, generally, it should not exceed 10-percent of your company’s revenues.

How can invoice Factoring help with deficient or negative working capital?

It stands to reason that once cash flow is holding the company back, an ideal source of short-term financing could be a lifesaver. Overdraft facilities of bank loans work for some, but banks have become much tougher on the business they will lend to. Invoice factoring is, thus, becoming an increasingly popular solution for these cash squeezed companies. Via this system, businesses sell their invoices to a third party (known as a factoring company or a factor) at a slight discount. This gives them the cash flow they require and can prove an effective method of improving the working capital cycle. 

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