What is working capital, and how can I manage it?
Every small business owner needs two tools to maintain business operations: coffee and a healthy amount of working capital. Working capital refers to the amount of available capital a business has to cover daily expenses and operating costs, like payroll, rent, and supplies.
Another way to define working capital is the difference between a company’s current assets and current liabilities.
Assets refer to anything of economic value the business owns, like cash, accounts receivable, equipment, or property.
Liabilities refer to your business’ various forms of financial debt, like accounts payable, salaries payable, income taxes, or loan payments.
Ideally, you want your business to have more current assets — the assets you expect to liquidate within 12 months — than current liabilities, which are liabilities you need to pay within 12 months.
The amount of working capital your business has is a good indication of your company’s financial health, so it’s important to crunch the numbers to see where you’re at.
How do you calculate working capital?
You can calculate your business’ working capital by using the following formula:
Review your balance sheet to total up your current assets and current liabilities. If your business has $250,000 worth of current assets, for example, and $175,000 worth of current liabilities, then your business has $75,000 of working capital.
However, while it’s helpful to know this figure, the flat dollar amount doesn’t always provide the best overview of your working capital.
To get a better understanding of how your business is functioning, you need to calculate your working capital ratio as well. Here’s how to calculate it:
Using the previous example, if your business has $250,000 in current assets and $175,000 in current liabilities, your working capital ratio would be roughly 1.4.
Anything below 1 indicates negative working capital, anything above 2 suggests positive working capital, and a ratio between 1 and 2 is considered a healthy number.
Analyzing the numbers
Get into the habit of keeping quarterly and annual records of your assets, liabilities, and working capital. Examining the numbers, particularly your working capital ratio, can clue you in to what you’re doing right, as well as what you can improve upon.
When you look at the data, you might see a boost in profits, for example, but if your current liabilities increase rapidly at the same time, you could end up with a negative working capital ratio. If that’s the case, you’ll likely have a more difficult time paying off short-term debt. And falling behind on short-term payment commitments can kickstart a dangerous cycle in which you accumulate more and more debt until your business is at risk of bankruptcy.
On the other hand, your business might have the same profits year after year, but if you manage to reduce your current liabilities — by refinancing your debt, for example, or paying off a loan — you may end up with greater working capital despite seeing no increase in overall profits.
When your business has positive working capital, it’s viewed as having good short-term financial health. But keep in mind that higher working capital doesn’t necessarily equate to guaranteed financial success and ease of operations. If you can’t liquidate your current assets in time to pay for your current liabilities, you might experience a temporary cash shortage.
In any case, the key to strong working capital is smart management. Here’s what you need to know about balancing your assets and liabilities.
3 ways to manage working capital
1. Expedite receivables
It doesn’t matter how substantial your accounts receivable is; the money owed to you may technically increase your current assets, but you can’t pay down current liabilities with unpaid invoices.
To ensure your money comes in on time, send invoices as soon as possible and see if you can negotiate a faster payment time, like 15 days instead of 30. It’s also important to check that your vendors are paying you on time. If they’re not, start including the payment timeline in your correspondences and make sure it’s visible on invoices, too. If a vendor regularly defers payments, you may need to revise your contract to include a clause about late payment fees, then let your contact know about the change in policy.
2. Don’t overbuy stock
Good inventory management contributes to a healthy working capital. A large inventory increases your current assets, but having too much inventory can also become a liability. If you overbuy stock and aren’t able to sell the amount you planned to, you could end up paying more in storage fees. Worse yet, if your stock has a limited shelf life, like food or flowers, you might have to eat the cost of the items that went bad.
To prevent this from happening, it’s critical to watch your stock levels, hone your sales forecasting techniques, and maintain clear communication between different departments.
3. Plan ahead
At least once every quarter, set aside time to review your balance sheets, upcoming expenses, and schedule. Do you have a company retreat to pay for next quarter? Are you issuing bonuses soon, hiring a full-time employee next month, or starting office renovations next year? An online tool like Float automatically updates your cash flow information, so you always know what you’re working with.
It’s crucial to consider your financial obligations, as well as your assets, well in advance; that way you can assess whether you have enough funds to carry out your plans and budget accordingly.
Do you have enough working capital to achieve your business goals? If not, learn how you can improve it.