What You Need to Know About Working Capital
Entrepreneurs, whether managing a big or small business, should be fully aware of their working capital. If you are just starting a business or have no formal education related to business management, you may ask, “What is a working capital?” Your initial working capital is important, as it is an indicator of the overall financial health of your business. Let us explain to you more about what it is and its importance.
What Is Working Capital?
Investopedia defines working capital as the “difference between a company's current assets and its current liabilities.” Working capital is also referred to as net working capital or NCW.
When we say current assets, we refer to assets that be converted into cash if necessary for the continuous operation of a business. These include, aside from cash, stocks and securities, accounts receivable, and inventories, whether raw materials or finished products. Note that for an asset to be considered current, it should be possible to sell or liquidate within a year. You may need to exclude pieces of machinery or properties that will be difficult to sell in one year from your list of current assets.
Current liabilities, meanwhile, are financial obligations that a company has to settle also within one year. They may include short-term loans, accounts payable, and income taxes.
How to Calculate Working Capital
How to solve working capital equation is easy. It can be calculated simply by subtracting its current liabilities from its current assets. For example, if Company A has current assets worth P5,000,000 and current liabilities worth P4,000,000, its net working capital is P1,000,000.
A business may also want to know its working capital ratio, which is calculated by dividing its current assets by its current liabilities. Going with the same example above, Company A’s working capital ratio is 1.25.
Why Is Working Capital Important?
Your working capital or working capital ratio is a reflection of your business’ short term financial health. For working capital, you want it to be positive, as it means you have enough sources of funds for your business’ operations and financial obligations, or even have extra for business expansion. For the working capital ratio, the ideal figure is between 1.2 and 2. If the ratio is lower than 1, then your business may encounter liquidity problems.
A very high working capital or working capital ratio is not always good, as it means you have too much assets on hand that you could have been investing somewhere else, like the expansion of your business to generate more income.
How to Manage Capital?
- Manage your inventory. If your business involves selling products, implementing an effective inventory management allows you to have easy access to stocks while reducing lead time, improving your sales and income.
- Improve your cash flow. Are there seasons where sales are high, while there are times when sales are almost zero? Or are most of your receivables come in at certain times of the year, but payables are regular? By keeping track of your cash flow, you can identify cash gaps, where you can make of any cash surplus.
- Increase your assets. By knowing your working capital, you get a glimpse of where you may need to cut corners to save cash. For example, suppliers may offer discounts for advance payments, which you may avail of. Also, you maya void short-term debts if you think borrowing money is unnecessary.
- When the cash flow gap is hard to fill. This is true for companies whose income is great only in certain seasons.
- When unexpected expenses are too high. Importers may not have anticipated the strengthening of the dollar against the peso, raising the cost of raw supplies.
- When inflation is high. Inflation has great implication on the costs of materials and services. Businesses may require additional funding for their working capital in such cases.