How to Maximize Your Significant Working Capital
A Guide to Understanding its Importance and Implementing Growth Strategies
By: Steven Whitehill
While you may already understand the significance of cash flow in managing your business’s finances, it is equally vital to monitor your working capital. Though cash flow and working capital share similarities, they are not interchangeable concepts. Working capital, like cash flow, serves as an essential metric to evaluate your business’s financial well-being.
Working capital, sometimes referred to as net working capital, refers to the funds available to cover a business’s daily operating expenses such as payroll, lease, and utility payments. It is calculated by subtracting current liabilities, or short-term financial obligations payable within 12 months, from current assets, which include cash and cash equivalents, accounts receivable, inventory, and prepaid expenses. Examples of current liabilities include accounts payable to suppliers and vendors and monthly loan payments.
To calculate your working capital, subtract your current liabilities from your current assets (current assets – current liabilities = working capital). You can locate these figures on your balance sheet. For example, if your current assets are $100,000 and your current liabilities are $70,000, your working capital is $30,000.
A positive working capital is preferable since it suggests that you have sufficient funds to cover your regular operating expenses. Negative working capital implies that you don’t have enough money to pay off your short-term debts as they fall due, although it could be caused by temporary factors. Negative working capital on a regular basis, on the other hand, might be a concern.
The working capital ratio, or current ratio, measures a business’s liquidity. To calculate this ratio, divide your current assets by your current liabilities. A ratio between 1.5 and 2.0 is considered healthy, indicating that you have enough funds to cover short-term liabilities and provide a financial cushion. If the ratio falls below 1.0, it indicates that your business may have trouble meeting its obligations. An excessively high ratio may mean that your business has funds that could be invested more effectively.
Working capital and cash flow are both important measures of a business’s financial health, but they are different concepts. Cash flow refers to the amount of cash a business generates in a given time period, while working capital takes short-term liabilities into account and compares them with short-term assets to see if a business can meet its monthly financial obligations.
To increase working capital, businesses can reduce costs, increase prices, manage inventory effectively, invoice earlier, negotiate payment terms with vendors, or consider working capital financing such as a line of credit or a working capital loan. Monitoring working capital and its ratio can provide a snapshot of a business’s current financial health and help in future planning.
Cash flow and working capital are often used interchangeably, but they are different concepts. Cash flow is the amount of cash that a business generates within a specified period, while working capital measures a company’s short-term liquidity and ability to meet financial obligations.
Working capital considers short-term assets and liabilities and calculates the difference between them. High working capital is typically accompanied by positive cash flow, but not always. For instance, a company with a high debt load may have positive cash flow but a low working capital.
Here is an example to explain how cash flow and working capital can differ: Alpha Beta Corporation generates a positive cash flow from selling high-end business accounting systems. However, the company’s heavy debt load and monthly loan payments increase its liabilities, leading to low working capital.
To increase working capital, businesses can implement several strategies, including cost reduction, price increase, efficient inventory management, early invoicing, negotiating with vendors, and exploring working capital financing options. While it is ideal not to require additional working capital, there are working capital loans available. However, businesses should keep in mind that when subtracting the cost of working capital from their profit, the remaining profit should still be reasonable for their specific business. It is crucial to remember that typical main street businesses generate between 15% and 25% profit on sales. For instance, if a business generates a profit of 20%, and the cost of borrowing money is 5%, it will still earn 15%.
Nevertheless, businesses should not only consider percentages but also the actual dollar amount. For example, if a business earns $100,000 in profits from $500,000 in sales, and the cost of a working capital loan is $25,000 or 5%, the remaining $75,000 might not be sufficient for the company’s needs. In conclusion, monitoring working capital and its ratio can help businesses gain a better understanding of their current financial position and plan for the future.
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