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Running a successful business often means a delicate balancing act in your cash flow, managing money moving in and money moving out. While cash flow is a useful measure of your business’s financial health at a point in time, it doesn’t take into account other important categories like liabilities and assets.
That’s why it’s vital you also have a handle on your business’s working capital. But what is working capital, and why is it so important? Here’s everything you need to know about it, including the working capital formula and how you can improve your business’s working capital.
What is working capital?
In a nutshell, it’s the difference between a business’s current assets and liabilities, and that amount is your operating liquidity.
Assets:
- Money in business bank account(s)
- Accounts receivable (money owed to you)
- Inventory (materials and products)
Liabilities:
- Accounts payable (money you owe, to suppliers etc)
- Business debts
Working capital formula: Current assets – Current liabilities
What is negative net working capital?
If your business’ liabilities exceed its assets, you will have negative net working capital.
Negative working capital can be a bad thing for your business because it means you have more short-term liabilities than short-term assets. In other words, the business is relying on financing to cover its current operating expenses.
While this might be manageable in the short term, it can create a number of problems for your business over time. For example:
Liquidity issues: If a company has negative working capital, it may not have enough cash on hand to cover its immediate expenses. This can lead to cash flow problems, which can make it difficult to pay suppliers, employees, or other expenses.
Limited growth opportunities: Negative working capital can also limit your businesses’ ability to invest in growth opportunities. Without access to capital, you may struggle to invest in new products or services, expand operations, or make strategic acquisitions.
What is positive net working capital?
If your business’s current assets outweigh its current liabilities, it has positive working capital. This means it has sufficient short-term resources to cover its short-term debts and operating expenses.
Having positive working capital can be beneficial for your business in several ways:
Improved liquidity: Positive working capital means that a business has enough cash on hand to cover its immediate expenses, such as payroll, rent, and other operating costs. This can improve your company's liquidity and reduce the risk of cash flow problems.
Better financial health: Positive working capital is a sign of financial stability and strength. It indicates that your business is generating enough cash to meet its short-term obligations, which can be attractive to lenders, investors, and other stakeholders.
Increased flexibility: With positive working capital, your business can be more flexible in its operations. For example, you can take advantage of discounts from suppliers by paying bills early or investing in new growth opportunities.
Improved resilience: Positive working capital can also help your business weather economic downturns or other unexpected events. With enough cash on hand, you can continue to operate even during difficult times, such as a recession or supply chain disruption.
Overall, positive working capital is a desirable financial position for a business. It can provide a range of benefits that can help a company thrive and grow over the long term.
What is operating working capital?
Operating working capital refers to the amount of capital required by a business to fund its day-to-day operations. This includes buying and selling stock, and paying suppliers and employees.
The formula for calculating operating working capital: OWC = Current assets - non-operating current assets
It’s important to note that this calculation excludes cash and short-term debt.
Whilst cash is categorised as a current asset, it is not factored in the calculation because it is considered a non-operating asset. This is because holding cash is not directly linked to the company's operations. Instead, cash becomes an operating asset once it is used to purchase supplies or other items required for the company's operations, and can then be included in the operating working capital calculation.
What affects working capital?
Several factors can affect a company's working capital, including the management of its receivables and debtors, stock levels, and payables and creditors.
Receivables and debtors
Receivables and debtors are the amounts owed to your business by its customers. When customers take too long to pay, it can put a strain on your company's working capital, as you have to cover its expenses without the expected cash inflow.
Effective management of receivables and debtors, such as invoicing promptly and setting clear payment terms, can help improve your company's cash flow and working capital position.
Stock
Stock, or inventory, is the goods or raw materials that your company holds for sale or production, such as candles, flowers or food products.. Excessive stock levels can tie up a significant amount of your company's working capital, while insufficient stock levels can lead to lost sales and reduced revenue. Therefore, managing stock levels effectively is critical to maintaining a healthy working capital position.
Payables and creditors
Payables and creditors are the amounts owed to your business by suppliers and vendors. Delayed payments to creditors can damage your company's relationships with its suppliers and harm its creditworthiness. Effective management of payables and creditors, such as negotiating favourable payment terms and prioritising payments to avoid late fees, can help preserve your company's working capital and also maintain good supplier relationships.
Why is working capital important to my business?
Ultimately, the amount of working capital in a business shows how well (or not) it's performing. Whether it’s to help shape business strategy or to show investors the business is worth investing in, working capital is an important part of understanding your business’s financial health.
If your working capital is somewhat low, you might struggle with unexpected expenses and your ability to grow the business. You might think that the higher your working capital, the better, but too high could be an indication that you have too much money tied up in inventory or cash that you’re not reinvesting properly.
How to calculate your working capital ratio
There’s more to understanding your business’s working capital than just the value of it, and that’s where working capital ratio comes in. Different businesses might easily have the same amount of working capital, but they could have very different positions in terms of assets and liabilities.
Working capital ratio= Current assets/Current liabilities
To calculate working capital ratio, divide your current assets by your current liabilities. This gives you your working capital ratio, and will generally be a figure between 0.5 and 3.
Let’s compare two hypothetical businesses:
Business A has assets totalling £500k and liabilities totalling £200k.
Working capital: £500,000 - £200,000 = £300,000
Business B has assets totalling £1.25m and liabilities totalling £1m.
Working capital: £1,300,000 - £1,000,000 = £300,000
So we can see that the value of working capital that both businesses have is the same, but does the working capital ratio tell us more?
Business A
Working capital ratio: 500,000/200,000 = 2.5
Business B
Working capital ratio: 1,300,000/1,000,000 = 1.3
In both of the above examples the value of working capital is the same, but the working capital ratios reveal different financial positions.
The ideal working capital ratio is between 1 and 2. Less than 1 suggests there could be issues with liquidity in the future, and above 2 indicates a potential problem with cash not being reinvested back into the business.
What is the working capital cycle?
The working capital cycle is the amount of time it takes for a business to convert its current assets into cash, and then use that cash to pay off its current liabilities. It's a measure of a company's ability to manage its short-term liquidity and cash flow.
The working capital cycle typically begins with the purchase of inventory or raw materials, which are then turned into finished products and sold to customers. The business then collects payments from customers, which are used to pay off suppliers and other short-term debts. The cycle then starts over again with the purchase of new inventory or raw materials.
How to improve your working capital
If you think your business’s working capital could be improved in order to access more opportunities and drive growth, there are ways to do it.
Reduce your expenses
Look at where your business can reduce costs. When you do this, it’s important to measure the savings you might make with the impact on your employees or customers.
Work on bad debt
Bad debt, or outstanding invoices that you haven’t been able to collect, can really impact working capital. Work on resolving any queries that has led to your customers withholding payment, and sharpen your credit control/accounts receivable processes to try to avoid more bad debt from accumulating.
Tighten up inventory management
Holding on to inventory, be it stock or materials, is a drain on your liquidity. You don’t want to hold too little that you can’t fulfil customer demand, but work on optimising inventory to get the right balance.
Look for funding
There are a number of potential funding sources available to improve working capital, and two of the most common are working capital loans and business credit cards. Working capital loans are, as the name suggests, specifically for this purpose. Business credit cards, on the other hand, offer much more flexibility.
What is the difference between net working capital and cash flow?
Net working capital is the difference between a company's current assets and its current liabilities. It is a measure of a company's ability to meet its short-term obligations and is an indicator of its liquidity.
Cash flow, on the other hand, refers to the movement of cash in and out of a business over a specified period. It reflects the amount of cash generated by a company's operations, as well as its investments and financing activities. Cash flow is a measure of a company's ability to generate cash and its capacity to fund its operations and investments.
Both metrics are important for evaluating a company's financial performance and health, and they are often used together to provide a more complete picture of a business's financial situation.
This does not constitute financial advice. If you want to understand your working capital in detail, you should speak to your financial advisor or accountant.
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