It can be tricky to see the whole financial picture of your business. With short term debts like utility bills, wages, and taxes going out of your business while sales are coming in – wouldn’t it be great to have a clear indicator of your financial health?
Working capital is just that. And while it may sound like a corporate buzzword, working out your working capital can be beneficial for businesses of all sizes. So what is the working capital meaning and why is it important? And how do you work it out? Read on to find out:
Read more top tips on managing your business finances.
What is working capital?
Working capital, sometimes called net working capital (NWC), is a budgeting metric that helps you understand the financial health of your business. It shows the amount of money you have readily available in your business to cover your short-term costs after paying off your short-term debts.
Put simply, it helps you know how much money you have left once you’ve paid for everything you need to. To figure out your working capital, there’s a few terms you’ll need to understand to get started.
Liquid assets
A liquid asset is something you own in your business that can be quickly turned into cash without it losing much value.
Physical cash, bonds, stocks, and money in easy access bank accounts are all considered liquid assets. Things like company cars, specialist equipment, and property wouldn’t be because they’re more difficult to sell quickly.
Learn more about how to develop your understanding of asset finance.
Liquidity
Liquidity is a term that describes the type of assets you have in your business and how easily they can be turned into cash. Your business can be in a state of high liquidity or low liquidity.
- high liquidity means you have lots of liquid assets in your business that can be exchanged for cash quickly if you need to
- low liquidity means the opposite, that you have lots of assets that are more difficult to sell quickly
Find out more about liquidity in business and how it works.
Current assets and liabilities
These are the two key metrics to work out your working capital:
- your current assets are items in your business like cash, inventory, equipment, and property that have value
- the money and services you owe are your current liabilities, like wages, tax, and bills
How to calculate working capital with a formula
You can find out the working capital of your business through a simple formula. The basic formula is: your current assets – current liabilities = your working capital.
So if the current assets in your business are worth £100,000 and your current liabilities are £80,000, your working capital would be £20,000.
The example above would be described as a positive working capital because the number is above zero.
It’s when businesses end up with a negative working capital that something needs to change.
You’ll also need to consider the liquidity of your assets. Even if you have a positive working capital, assets with low liquidity could cause problems in the future.
Read on for more examples of a positive working capital and negative working capital.
Example: positive working capital
A family gardening business has the following assets:
- cash – £55,000
- equipment – £35,000
It also has liabilities, including:
- wages – £45,000
- tax – £6,500
- credit card debt – £2,000
Working capital calculation: The business’s assets (worth £90,000) minus its liabilities (worth £53,500) leaves it with a positive working capital of £36,500.
Example: negative working capital
A small marketing agency has the following assets:
- cash – £45,000
- equipment – £7,500
Its current liabilities are:
- wages – £75,000
- tax – £10,500
- business loan – £7,500
- utility bills – £5,000
- rent – £15,000
Working capital calculation: The business’s assets (worth £52,500) minus its liabilities (worth £113,000) leave it with a negative working capital of -£60,500.
Why understanding your working capital is crucial
For small businesses, maintaining a steady cash flow is crucial. Figuring out your working capital is a good pulse check on how easily you’ll be able to meet your financial obligations.
It can be easy to lose sight of how your business is doing financially because you can have lots of incomings and outgoings, which doesn’t give you a clear idea of what’s left. Not knowing or misjudging your working capital can lead to a variety of issues for your business like:
- failing to pay your suppliers
- falling behind on your bills
- increasing your debt
You can also view your working capital as your safety net. As it’s technically additional income, you could save it for a rainy day and add it to your sinking fund. Having extra cash for an emergency could help you get through a rough patch.
But understanding your working capital isn’t only about avoiding difficult financial situations – it’s also about working more efficiently, and seeing what headroom you have for growth.
You could plan to use 10 per cent of your working capital on investing in new equipment, for example. Or if you’re looking to sell your business, a healthy working capital is one of the financial measures potential buyers will be looking for.
So understanding and improving your working capital is a good idea for most businesses, regardless what stage of growth you’re in.
Find out more about balancing your business budget.
How to improve your working capital
There are a few different ways you can improve your working capital that aren’t just about making more money:
- managing stock – make sure you’re not overstocked or understocked, this way you’ll avoid spending too much in one go and protect your cash flow
- negotiating longer payment terms – with your regular suppliers, sometimes it’s possible to spread your costs over long periods to reduce your short-term debts
- checking credit scores – taking the time to check the credit score of a business can help you avoid late payments and keep a steady cash flow
Find out more about how to create a strong business strategy.
Common working capital challenges and how to overcome them
There are a range of business challenges that could affect your working capital, including:
- unexpected costs – these can make it harder to plan and manage your finances. Having cash reserves in place can help you to stay on track
- late payments – if customers don’t pay, you might struggle to pay your short-term debts. Make sure you have clear payment terms and a process in place to chase outstanding payments
- seasonal fluctuations – if you have ups and downs throughout the year, there could be times when your finances are stretched. Again, having healthy cash reserves can help you to get through the leaner periods
- poor stock management – overstocking could mean your business has cash it might need to pay debts tied up in assets, while understocking could lead to missed opportunities and lower income. That’s why it’s important to make sure you understand the supply and demand of your customer base and complete a regular and thorough stock take
Working capital vs cash flow – what’s the difference?
Working capital is a snapshot of a business’s financial health from a specific moment in time. It can be worked out using information taken from the balance sheet.
Cash flow shows the money coming in and out of a business over a period of time (e.g. a month, quarter, or year). You can work out your cash flow using a cash flow statement.
Working capital and cash flow are closely linked and impact each other. Working capital shows what funds you have available to pay debts, while cash flow shows how those funds have become available through income and expenditure.
Recap – what is working capital?
Working capital is a simple way to get an indication of your company’s financial health. It measures how quickly and easily you can convert assets into cash and, as a result, whether you’re in a good position to meet your short-term financial obligations.
Businesses with a healthy working capital are able to improve or expand through investment. Those with a negative working capital could be at risk of financial difficulty in the future.
Read more tips on boosting your business profit.
Working capital FAQs
What is working capital in simple terms?
Working capital is a simple formula to work out the financial health of your business. By subtracting your costs from your assets, you get a number which is an indication of your position. If the number is above zero, you have a positive working capital. If it’s below zero, your working capital is negative.
How does working capital management differ for product-based vs. service-based businesses?
If you run a service-based business, you won’t have physical products so inventory management won’t be a priority. However, you’ll need to focus on billing for projects and collecting payments on time to have a positive working capital.
For product-based businesses, solid inventory management and supply chain management will have the biggest impact on working capital.
Can a business have too much working capital? If so, what are the risks?
If a business has a positive working capital, it’s always likely to be better than having a negative working capital. However, there are risks associated with having a high working capital ratio.
Having too much working capital could indicate that a business isn’t using its assets effectively. Being overly conservative could mean a business misses opportunities for investment or expansion.
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