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What Is Working Capital?

What Is Working Capital?

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What Is Working Capital?

What Is Working Capital?

Working capital, or the day-to-day resources that help a business function, plays a key role in small business profitability or lack thereof. Working capital can also indicate the operational efficiency of a firm. 

The Accounting Definition of Working Capital

Accountants and financiers define working capital with the following simple calculations:

Working Capital = Current Assets – Current Liabilities

Investment bankers usually remove cash and short-term debt from this working capital formula, but for our purposes we will make use of this equation to explore the importance of managing working capital effectively.

Accountants also often express working capital management as a ratio:

Working Capital Ratio = Current Assets / Current Liabilities

A business with $1000 in current assets and $500 in current liabilities would then have a working capital ratio of 2. 

Current Assets

Examples of current assets usually include:

  • Cash and Cash Equivalents
  • Accounts Receivable
  • Inventory
  • Prepaid Expenses
  • Other Forms of Liquid Assets (Marketable Securities)

Current Liabilities

Examples of current liabilities include the following types of accounts:

  • Accounts Payable
  • Accrued Liabilities (Wages Payable, for example)
  • Short-Term Debt

Net Working Capital (NWC)

Net working capital simply takes a company’s existing cash, accounts receivable, inventory, prepaid expenses, and other liquid assets and subtracts accounts payable, accrued liabilities, and short-term debt. 

Companies with positive working capital have more current assets than current liabilities, while companies with negative working capital have more current liabilities. Negative working capital can indicate problems with a business or demonstrate its operating efficiencies. 

Alternative Definitions of Working Capital

Some financiers will recalculate working capital as current assets less cash minus current liabilities less short-term borrowings. This modification typically comes into play for mergers and acquisitions. 

Why Working Capital Management Matters for Small Businesses

For most small businesses, working capital keeps the lights on. Without sufficient cash on hand to cover everyday expenses such as labor and payments owed to creditors, a business won’t survive long. 

Employees require wage payments for their labor, landlords require rent payments, utility companies require payment for electricity, gas, and water, and lenders such as banks and credit unions require businesses to make interest and principal payments in a timely manner. 

Some small businesses must pay suppliers immediately while allowing customers to pay later. This type of scenario can lead to working capital problems and potentially bankruptcy if a business fails to find the cash necessary to make these payments elsewhere.

How to Calculate Working Capital

To model a few different scenarios that might lead to working capital management problems, consider the previous example where a business had no choice but to pay suppliers immediately while allowing customers to defer their own cash payments. For this example, assume that the customers owe the business $1000 while the supplier demands an immediate cash payment of $500:

Cash in the bank = $0

Accounts receivable = $1,000

Supplier payment = $500

Cash Flow from Operations = -$1,000 (since A/R acts as a use of cash on the cash flow statement)

In this scenario, a business cannot meet its obligations without relying on external financing, thereby creating a gap between the amount of cash owed and the amount of cash on hand. 

The opposite scenario might occur, too. Consider a business that collects cash from its customers immediately and can defer its payments to suppliers. 

Cash in the bank = $1,000

Accounts payable = $500

Working Capital = CA – CL = $1,000 – $500 = $500

This scenario ensures that the business can meet its obligations and even store cash for a rainy day. By maintaining positive working capital, a business can ensure its short-term financial health.

Other common working capital calculations include:

  • Quick Ratio: Cash + A/R + Marketable Securities / Current Liabilities
  • Current Ratio: Current Assets / Current Liabilities 

Retail businesses, some of the most common small businesses, must typically pay for inventory in advance of the sale of that same inventory. These purchases often negatively affect cash flow from operations prior to the revenue recognition moment.

The average retail company’s current assets might include inventory such as goods for sale, any cash in the bank, and deferred payments from customers expressed as accounts receivable. Its short-term liabilities might include accounts payable to suppliers, wages payable, and other common liabilities for a retail operation.

Service-based industries may also encounter working capital problems. For instance, consider a small advertising agency which allows its clients to pay in net 30 terms. This agency may only collect payment from clients at the end of the month but must make employee payments twice per month, thereby leading to a potential cash shortfall. 

Working Capital Financing Methods

For businesses that face a gap between their current expenses and cash, working capital financing may help to bridge it. Several types of these products exist, including a line of credit, invoice factoring, and merchant cash advances. 

Identifying Working Capital Problems in Your Business

The key to fixing working capital management issues in your business revolves around the proactive identification of future current assets and liabilities. 

For instance, consider offering discounts to invoiced customers who make swift payments. Small business owners should also consider using external financing such as revolvers or factoring services to smooth out free cash flow over the working capital cycle.

Businesses that operate in the retail sector should also constantly negotiate for better terms on payments to suppliers as well as limit the amount of credit they extend to customers. 

Finally, a smart business owner will also keep a close eye on the balance sheet and operational cycle of the business on a day-to-day basis. This continuous process ensures that owners will never encounter operational surprises.

What Is Working Capital?

What Is Working Capital?

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