What Is Working Capital?

Business Tips
Feb 21, 2024
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No matter what business you’re in, you’ve probably heard the term “working capital” before. But what exactly is it, and why is it so important? Let’s explore the ins and outs of working capital and why it matters for your business.

First things first, let’s define what we mean by working capital. Simply put, working capital is the amount of money a business has available to cover its day-to-day operations. It’s calculated by subtracting a company’s current liabilities from its current assets. For example:

$120,000 in current assets – $70,000 in current liabilities = $50,000 in working capital

Current assets include things like cash, inventory, prepaid expenses, accounts receivable, things that can be turned into cash inside of the accounting year. Current liabilities include things like accounts payable, customer deposits (gift cards), short-term debt, items that need to be paid out within the accounting year.

So, why is working capital so important?

Well, for one thing, it’s essential for keeping your business running smoothly. Without enough working capital, you may not be able to pay your bills on time, meet payroll obligations, or purchase the inventory you need to keep your business going. But working capital is about more than just keeping the lights on. It’s also a key indicator of a company’s financial health. If a business has negative working capital, for example, it may be a sign that they’re struggling to meet their obligations and could be at risk of bankruptcy.

On the other hand, having too much working capital can also be a problem. If a business is sitting on a lot of cash or inventory that isn’t being used, it’s essentially tying up resources that could be used for other purposes, like investing in new equipment or expanding the business.

8 reasons why working capital is crucial for a business:

1. Liquidity and Operations:

Adequate working capital ensures that a company has enough liquid assets to cover its short-term obligations. This allows the business to operate smoothly without disruptions in its day-to-day activities.

2. Cash Flow Management:

Working capital management is essential for maintaining a healthy cash flow. It helps businesses meet their short-term financial obligations, such as paying suppliers, employees, and other operational expenses.

3. Flexibility and Opportunities:

Sufficient working capital provides flexibility to seize opportunities or address unexpected challenges. It allows a business to take advantage of supplier discounts, invest in growth opportunities, or weather economic downturns.

4. Creditworthiness:

Lenders and suppliers often assess a company's working capital position as an indicator of its financial health and creditworthiness. A strong working capital position enhances a company's ability to secure favourable credit terms and maintain good relationships with suppliers.

5. Seasonal Fluctuations:

Businesses with seasonal fluctuations in sales and expenses rely on working capital to navigate periods of low revenue. It helps them cover expenses during slower months and build up inventory for peak seasons.

6. Risk Management:

Adequate working capital acts as a buffer against unforeseen events and economic downturns. It provides a safety net, reducing the risk of insolvency and helping a business withstand challenging market conditions.

7. Efficient Operations:

Effective working capital management ensures that a business can efficiently convert its current assets into cash. This efficiency is crucial for maintaining optimal inventory levels, managing accounts receivable, and minimizing excess cash tied up in non-productive assets.

8. Customer Relations:

Timely delivery and fulfillment of customer orders are essential for customer satisfaction. Working capital enables a business to meet these commitments by ensuring a smooth flow of operations.

Wondering how much working capital your business needs?

That can depend on a variety of factors, including the industry you’re in, the size of your business, and the stage of growth you’re in. Generally speaking, businesses should aim to maintain enough working capital to cover at least a few months’ worth of expenses.

One way to improve your working capital is to manage your cash flow more effectively. This might include things like negotiating better payment terms with your vendors, offering discounts to customers who pay early, or using technology to speed up your invoicing and payment processes.

Curious about how working capital fits into your business valuation? Chat with one of your experienced Intermediaries today.