What is Working Capital?

Working capital is a measure of how much liquid cash a company has after bills are paid. It is a short-term snapshot of the financial health of a company. When you have sufficient working capital, you are able to keep your company afloat. Suppose you find that you have an abundance of working capital. In that case, you can invest in your business by adequately paying employees, investing in software or marketing strategies, and having the cash flexibility to buy larger chunks of inventory at a time.

Working Capital Formula

Short-term Assets – Short-term Liabilities = Working Capital

When you take your current assets and minus your current expenses each month for your business, then you can calculate your working capital. Keep in mind that this is a short-term snapshot. You are working with numbers that are in the now, not projected numbers that you hope to have once x, y, and z are achieved.

What Are Small Business Current Assets?

To calculate your current assets, you can add the cash that you have on-hand to the guaranteed income you have coming in that month. Remember, when calculating working capital, we are focusing on the short-term.

There are a few different sources of current assets:

  • Liquid cash-on-hand and in your business account
  • Accounts receivable, the money guaranteed to come in from clients that month
  • Your inventory’s cash value
  • The current value of any investments

This number can be easily calculated when you keep a detailed accounting of your small business. Your accounts receivable should be easy to find and sum up. The cash value of your inventory could be found on the replacement value of what your inventory is worth today if you were forced to liquidate. And you can look up what your investments are currently worth if you were to cash out your stocks.

When you have identified your current assets, then you can use that number to calculate your working capital. This calculation will help you discover how financially healthy your business is.

What Are Current Liabilities?

The list of current liabilities can be quite long. This number is found by summing together all of your expenses. How much money goes out of your account each month in order to cover the bills? This can include:

  • Accounts payable, any money you owe for goods and services
  • Payroll payments to your employees
  • Payroll taxes and business income taxes that are incurred
  • Outstanding credit card balances
  • Loan payments
  • Rent on your office or store space

When you add up all of the expenses over a month, you will come up with your total in current liabilities. Having a good view of the cash that is outgoing in your small business will only benefit you. You will be able to clearly see how much you’re coming out ahead each month, rather than just guessing that all is well with your cash flow in your business.

How Does Working Capital Calculation Help a Small Business?

Now that you’ve found your current assets and current liabilities totals, you can calculate your working capital. Current assets minus current liabilities equals working capital. When you see your short-term financial balance, then you will see how much money you have to keep your business thriving each month.

If you take it a step further and see how your working capital can turn into long-term savings, then you can decide if you have room to invest that money into further growing your business.

There are several ways that you can invest in your business. Some of them being:

  • Invest in newer technology
  • Marketing and advertising
  • Rebrand with a more modern design of business logo and website
  • Buying more inventory to prepare for a busy season
  • Employee training programs

Investing in your company will set up your small business for future success. It may feel comfortable to stay stable and keep your business profits consistent and even. Why not maintain your business rather than seek constant growth? You will never regret challenging your comfort zone and standing behind your business by growing it.

Before you take all the extra cash that you have each month and invest it all, there is more to working capital. It may be comforting to know that your working capital is in the positive, but you want your current assets to stay higher than your current liabilities. And you can calculate a new number, a working capital ratio, to know how much higher you would like your existing assets to stay.

Working Capital Ratio

The working capital ratio is calculated by taking your current assets and dividing it by your current liabilities. For example, if your small business is bringing in $3000 per month and your total expenses come out to $1500, then the working capital ratio would be 2:1.

A 2:1 ratio is considered to be very healthy for a small business. It is essential to keep your ratio in a healthy range, and it changes business to business. Some industries can have a working capital ratio as low as 1.2:1 to operate sufficiently. Your working capital ratio will be examined when it comes to applying for loans or lines of credit. That’s why it’s always important to know what it is.

How Can a Small Business Increase Its Working Capital Ratio?

One way to increase the working capital ratio is to cut costs. This may mean laying off employees, finding different vendors for your inventory, finding an office or store space with lower rent, or taking a lower paycheck yourself. It may be tempting to keep things as is if you’re not in the red each month, but the focus on increasing your ratio will set you up for long-term small business success.

Another way that you can increase the ratio is to increase short-term assets. This can be done by raising the prices of your goods or services. Adequate research can be done to determine if you have room to raise prices without losing customers. Sometimes a small increase can make the difference in your working capital ratio that you need for your specific industry.

Lastly, you can always apply for a small business line of credit loan or use a business credit card. While these are not ideal solutions, as it will increase your long-term liabilities, it may be the boost your business needs to get through a hard time.

Cash Conversion Cycle

Now that you’ve calculated your small business’s working capital and know your working capital ratio, it is notable to talk about the cash conversion cycle. This is the time in between when money goes out, and money comes in. If you have a 30-day cycle, that means you have paid all your bills and are waiting for funds to come in for 30 days. For those 30-days, money is tight, and there isn’t room for emergencies. Your goal is to get your cycle down to the least amount of days as possible.

This might mean giving your clients less time to pay their bills. If you have a piano teaching business, you may require your customers to pay at the beginning of each month. This is better than paying each lesson day or billing them and giving them time to pay later. It will decrease your working capital cycle.

Or if you have a haircutting business and find it awkward to ask for money in person, you may send out bills each month and give them 7-days to complete the invoice. The goal is to increase the cycle of waiting for payments to not wait between incurring expenses and getting paid. Requiring real-time payments or even asking for payments in advance will decrease your working capital cycle time and be healthier for your small business.

Working Capital Explained

Now that you have all the information regarding working capital, you can use that knowledge to set your business up for success. It is essential to have your working capital in the positive, making sure that your current assets are more than your current liabilities or expenses. And then take it a step further and ensure that the ratio between the two is a healthy ratio for running a business.

Each small business is different, but working capital is universal. A healthy working capital ratio is something that every small business needs to thrive. If you are passionate about other parts of your business, including customer service, marketing, and manufacturing, it may be sensible to consult with a small business accountant.

Small Business Accounting Professionals

When you contact professionals who are well-versed in small business practices, then you will know that your business is in good hands. Take the stress out of working capital and leave it to the experts. You can sit down together and find the best working capital ratio for your business specifically. Save yourself stress by seeking small business accounting services today.

Our goal at Easier Accounting is to make your job easier. With our expertise in small business accounting, we can answer any questions you might have regarding your business. When your accounting is in order, your business is set up for success. Give us a call at (888) 620-0770.

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