Working capital is often misunderstood! And because business owners are unaware of its meaning it leads them to problems.
For some focusing on cash flow is their main concern. Cash flow is extremely important and we would recommend you always monitor your cash flow.
But working capital is the lifeblood of any business and takes more than just cash into account.
Without working capital it is difficult for a company to operate, even if you have decent profits.
Cash flow is the net amount of money that is going to be paid in or out of the business in a set period of time, maybe seven days or a month.
Working capital shows what liquidity is in the business and demonstrates if you can pay off immediate liabilities. This article will help you understand working capital.
Working capital definition
The definition is usually ‘current assets minus current liabilities’. It basically means what your business has left in terms of cash and assets.
The figure can be positive or negative and keeping an eye this shows you the financial health of the business.
Your cash flow may show there is plenty of money coming in. What it doesn’t show are other assets the company owns, however, such as spare money in the bank or other items it owns that can be turned into cash.
While the cash flow may look healthy, the working capital could show that there is a lot of money owed. The cash coming in and the few assets may not be enough to cover what the business owes or to get you through a difficult patch.
This was one of the factors that led to the collapse of Thomas Cook. Yes, sales were down, but as this study shows, it was the lack of effective working capital management that was a major factor.
What are current assets?
This is what your company currently owns both in physical, tangible terms an intangibly that it can turn into cash easily in a set time, usually a financial year. It includes cash, unpaid invoices, business savings or stock (known as inventory).
These are what the firm expects to pay within the same period and usually includes the cost of running the business, such as rent, materials and utilities. Other current liabilities include dividends to be paid, leases and long-term debt that is coming due.
Working it out
Calculating working capital uses a ratio of current assets divided by current liabilities.
That is: Current Radio = Current Assets ÷ Current Liabilities.
A ratio above 1 means you have more assets than liabilities, which shows your business is healthy and has enough to get it through any tricky patch.
Ratios that are higher than 1 means the company can easily fund its daily operation. If a business has more working capital it may not have to take on debt to fund its growth.
How to improve it
There are ways you can increase your working capital, which includes:
- Earning additional profits
- Faster invoicing terms
- Efficient collection of invoices
- Better inventory management
- Negotiating better payment terms with suppliers
If you need help, contact us and let us explain how we can help.