Definition
Working capital is the amount of funds available to a company for managing day to day operations. These daily expenses can include office materials, maintenance costs, rent and utility costs. It can be used to measure the financial capability to pay off short term borrowings and liabilities. The working capital cycle is considered as the time taken to convert short term assets into cash.
How to calculate working capital
Working capital is the difference between current assets comprising cash, accounts receivables, marketable securities and inventories, and current liabilities comprising accounts payable, short term loans and accrued liabilities. Working capital can also be evaluated with the help of a financial ratio and existing assets divided by current liabilities. If the resulting number is less than 1.0, it denotes that your current liabilities exceed your current assets resulting in negative working capital. And if the number is more than 1.0, it can be a sign of a healthy business. However, a very high number can denote slow-moving inventory on hand. Ideal working capital can vary depending on the line of business. Generally, a score between 1.2 and 2.0 is considered healthy.
Importance of working capital
To attract investors
Working capital is of utmost importance for businesses looking at potential lenders. Investors use this as a means to calculate the risk involved in lending to companies seeking business loans. Thus negative working capital can render your business a risky investment. Lenders consider businesses with positive working capital as more likely to pay off the debt in time.
For daily operations
The company’s ability to convert short term assets into cash is calculated with the help of working capital. Positive working capital indicates the firm’s ability to conduct daily operations. However, negative working capital might not always indicate poor financial health, as in businesses with high inventory turnover rates.
To support business expansion plans
Positive working capital backs up future expansion plans for business owners. When a company desires to grow, it often purchases additional assets to manufacture products or offer services quicker and larger. If a company experiences a problem conducting everyday activities, it would be ill-suited to meet rising consumer demands and technological advancements.
How to increase working capital
Companies with insufficient working capital cater to the risk of encountering financial insolvency, legal issues, liquidation of assets and potential bankruptcy. Thus, it is crucial to have adequate working capital management, and a working capital loan can help with this.
Additional Read: How much working capital does your business need?
To improve your working capital situation, focus on receiving cash payments, encourage customers to pay their invoices early, sell long-term assets for cash, or increase sales and revenues.
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