If you’ve spent any time discussing the financial health of your business with an accountant or bookkeeper, then you will no-doubt have heard the term working capital.
While there seems to be some confusion as to what this means, the term is quite simple to understand and is used to help you manage your business.
What is Working Capital?
Working capital is defined as the difference between your current assets and your current liabilities. These are normally figures that your accountant or bookkeeper calculates for you, and they are used by banks and other financial institutions to determine the financial position of your company and how able you are to meet your short-term financial obligations.
Your business’s working capital represents the liquidity of your business. Liquidity is defined as the amount of cash and near-cash assets that you can convert into cash at very short notice to enable you to meet your financial obligations.
If your business has healthy liquidity, it means that you can easily pay your bills for your stock and operating expenses, staff costs, and all the other general running expenses of your business.
Your working capital is a measure of how efficiently your business is running and it shows how quickly you can convert goods and services in your business into cash on hand.
Your level of working capital is a very good indication of how well you manage your business.
So, what do we mean by working capital and how do we calculate it?
What Do You Mean By Working Capital?
To calculate your working capital, you need to deduct your current liabilities from your current assets. If, after deducting your current liabilities from your current assets, you have a positive figure, one can conclude that your business is in a healthy position and you’re able to conduct day-to-day operations.
The Liquidity Ratio
The liquidity ratio is calculated by dividing your current assets by your current liabilities. It’s a very useful short-term financial tool to gauge how your business is doing and is also referred to as the working capital ratio.
Liquidity ratios are an important metric that helps us determine a business’s ability to pay its current debt obligations without resorting to raising finance outside of the business.
There are a variety of liquidity ratios, such as the current ratio, the quick ratio, and the operating cash flow ratio.
One will use a comparison of multiple accounting periods and multiple liquidity ratios to see what the condition of the company is. Changes in the company’s liquidity ratio reflect changing economic conditions.
As the company does better, the liquidity ratio improves, and the better it can cover its outstanding debts.
One way to compare the liquidity ratio of your business is to use it in comparison to other businesses within your industry or to compare it to industry benchmarks.
The liquidity ratios differ based on where your business is located, the size of your business, and the business cycle that you’re in.
For instance, if you are in the lawn care industry, you may well find that your liquidity ratios are better during the summer months than during the winter months.
However, your particular geographic location may bring up anomalies that change the ratios. And the only way to establish whether this is the same as other companies in your industry is to compare industry benchmarks.
Let’s look at what current assets and current liabilities are.
So, what are current assets?
Current assets can be defined as cash or cash equivalents, accounts receivable, any and all stock that you’re holding in inventory, marketable securities, and any prepaid liabilities and other liquid assets that you can convert into cash at very short notice.
Another name for these assets is current accounts.
Now we come to current liabilities.
Current liabilities refer to any financial obligations that your business might have that are payable within the next 12 months.
These liabilities are usually transactions that you have undertaken with the expectation that there will be some payment due in one or other form of financial resource that is needed to cover the cost.
An Example of Working Capital
Let’s suppose that a business has current assets of $500,000 and current liabilities of $300,000.
Deducting $300,000 from $500,000 gives you $200,000.
The working capital of the business is, therefore, $200,000.
We now calculate the current ratio.
If we divide the current assets by the current liabilities, we obtain a ratio of 1.67:1.
It is usual for us to expect a ratio of 2:1 with a financially stable company.
But without further information about the industry and specifically about the ratios of other similar businesses, it is hard to know whether this is a good or a bad thing.
The 4 Main Components of Working Capital
For small and medium-sized businesses, the four components of working capital over which you have the most control are:
- Cash and cash equivalents.
- Accounts receivable (AR)
- Accounts payable (AP)
The most important thing a business needs to survive is cash flow. Working capital is a reflection of how well you manage your cash flow.
It is a constant balancing act, knowing how much cash to keep available, chasing your accounts receivable without scaring them away, and having enough inventory on hand to meet customer demand.
You then need to negotiate terms with your suppliers so that you can keep your accounts receivable up to date, without alienating them and having to find alternate suppliers.
This is where iKahnCapital can assist you in raising working capital to finance your business needs.
At times you will need to raise additional working capital to meet demand or grow your business.
You may have some unexpected expenses or need additional equipment to take advantage of a new opportunity. While it is great to be able to fund your expansion using your own resources, there are occasions when these may just not be enough.