What is working capital? Working capital can help provide a quick insight into your company’s loan repayment history and instill a greater sense of confidence. Read on to learn more.
Financial health is an important metric when sizing a business up for investment or credit. Anyone looking to put money into a company wants to know what their return on investment will be – or in the case of financing, they want to ensure that a company can clear its debts within the terms of the credit.
One of the most important metrics when looking at a company’s short-term financial health is its working capital. A company’s working capital, to put it simply, represents the difference between what they have (current assets) and what they owe (current liabilities).
When calculated and evaluated within the context of the company’s history (both in the long-term and over the last 12 months), this difference gives creditors and investors major insight into the business’s health and the viability of their investment.
Defining Working Capital
Working capital is what you end up with when you take your company’s current assets and subtract all your current liabilities. Common company assets might include:
- Cash reserves (i.e., petty cash)
- Your business bank account balance
- Accounts receivable (money from customers that hasn’t arrived yet)
- Undeposited cheques
- Cash equivalents (short-term investments)
- Stock inventory
- Raw material
- Miscellaneous supplies
On the other hand, common company liabilities include:
- Accounts payable (unpaid costs)
- Equipment leases
- Land leases
In short, for most companies, the math goes a little bit like this: accounts receivable + cash + inventory + materials + supplies – accounts payable – accrued expenses – loans, leases, debts.
If you have a $145,000 total in current company assets, including company-owned (not loaned or rented) property, equipment, inventory, cash reserves, accounts payable, and more, but $75,000 in outstanding expenses (payroll, taxes, accounts payable, utilities, loans, leases), then your total working capital would be $70,000.
Working capital can help give insight into a company’s liquidity and operational efficiency. If you have large working capital, you are in good financial health. You can use that capital to continue growing your business (by investing in more workers, more production space, more marketing, better equipment, and so on).
If you have negative net working capital, your business is in debt, and you may borrow from Peter to pay Paul. This indicates that the company is in rather poor financial health.
Should My Working Capital Be High?
If your working capital is excessively high, you may be in good financial health, but you are operating poorly. Capital that isn’t being reinvested to grow, either in the business itself or in short-term investments, is effectively wasted. You should not simply let the money sit there doing nothing at all.
In other cases, high working capital also means that the company produces more than it’s selling – meaning it has very high inventory. This isn’t good because a business with too much inventory isn’t getting rid of its stock. This company has to lower its prices, or there may be a problem with the product itself.
Your working capital is ideal when you always have the necessary reserves to survive a hard season or a dip in sales, but not so high that you’re losing out on money that you could be earning by reinvesting your capital.
Can You Change Your Working Capital?
Working capital is often an annual assessment of your company’s operational efficiency and financial health based on your current assets and current liabilities – which means that it is entirely flexible and likely to change every year (or at least it should).
Working capital illustrates, quite importantly, what level of financial commitment your company can safely make in a way that pure accounting profits would not be able to indicate.
You could seem to be in good health on a surface-level review of your books. Still, a tally of all your existing liabilities and assets over 12 months would provide a more sobering and realistic outlook from which to make decisions regarding how your net working capital should be reinvested.
Managing Your Working Capital
Ideal management of your working capital entails:
- Paying off every single one of your weekly, monthly, and periodic liabilities.
- Making investments into your company (based on where you may be bottlenecked, meeting demand, increasing your reach, branching out to different markets, etc.)
- Having enough cash reserves to survive foreseen shortages, as well as remaining prepared for unseen complications (from litigation to a worldwide shipping crisis).
For many companies, this is a science in and of itself. It requires careful knowledge and consideration of both your business and your industry’s history, both local and on a larger scale, an understanding of how seasonal your business is, signs of potential changes or issues with your customer base, potential competition, and much more.
For example, if you have $50,000 in net working capital at the end of the last quarter, it would be wildly irresponsible to dump it all on new equipment, especially if the increased production will only lead to larger inventory and no new sales, and no cash or assets on hand to absorb a loss.
Seeking Creditors or Investors
One of the primary reasons to measure and manage your working capital responsibly is because it reflects how your business operates within its industry – giving creditors and investors multiple crucial clues as to how risky of an investment your business would be, and in the case of creditors, making an impact on your rates and payments should you try to negotiate a loan.
Not all loans are as easy to qualify for as an SBA loan. Suppose you’re looking into borrowing options or are seeking investors for your business. In that case, your working capital can help provide a quick insight into your company’s loan repayment history and instill a greater sense of confidence in anyone agreeing to give you money.