How to Understand Working Capital To Improve Your Business

by | Aug 8, 2019 | Accounting, Business Management, Finance

Working capital holds the key to the success of your small business. Having adequate working capital keeps your business running. It allows you to pay your staff on time, buy inventory, sustain overhead costs, and other short-term expenses. In a way, working capital is your money available to meet current obligations. It will also determine how you can implement growth for the long-term. 

In this guide, we’ll help you calculate how much your working capital is and how you can improve on this to grow your business.

How to Calculate Your Working Capital

In the following calculations, consider only short-term assets such as:

  1. Amount of money in your business account
  2. Accounts receivable – which is the money that customers pay you
  3. Inventory that can be converted into cash within the next 12 months.

For short-term liabilities, include:

  1. Accounts payable – or the money you need to pay vendors
  2. Debts you have to pay
  3. Accrued expenses for staff’s salary, taxes, and other business expenses

You’ll get a sense of where your business is by calculating your working capital ratio. This ratio will determine the health of your business’s finances.

Working capital ratio = current assets / current liabilities

For example, if you have assets amounting to $500,00 and liabilities of $250,000, your working capital ratio is 2:1. This is considered a healthy ratio, while in some businesses a ratio of 1.2:1 is enough to keep things running. 

To determine how much money you have available to meet current expenses, you have to calculate your net working capital.

Net working capital = current assets – current liabilities

working capital concept

Understanding Your Working Capital

You can get a good grasp on what you truly need for your working capital by taking note of your cash flow every month. This includes outgoing and incoming cash. For example, if you are a retailer, there will be a big boost in sales during the holiday season and slow cash flow during regular months. You may use a spreadsheet for this as you plot your monthly cash flow or use tools such as Float or Pulse to view your cash flow in one place. 

Making cash flow projections may require you to look back at your monthly cash flow for the last 12 months and estimating the potential cash flow in the future. These projections will help you know when you have more money outgoing than coming in, and when the cash flow gap is widest. 

It may be difficult to make projections when your business is growing rapidly. Having a spreadsheet or tool will allow you to make changes to your cash flow forecasts as needed. 

Why You Should Consider Getting Additional Working Capital

Adding a little bit more to your working capital ensures that you’ve got something extra in case there are emergency expenses of contingencies. There will be certain months that cash flow is tight, and having additional working capital will help tide you over. 

Having extra working capital will help you prepare for the incoming busy months, and sustain the operations of your business during slow months. If there will be times that customers pay late, you can tap into your working capital to pay your obligations to suppliers and the government. 

Extra working capital will also improve your business in many ways. You’ll be able to pay for bulk expenses whenever suppliers offer a sale or fund new projects when the opportunity arises. 

How to Maintain Your Working Capital

You have to be careful when managing your working capital. You’ll need to separate short-term working capital from long-term business needs. If you want to purchase machinery, buy real estate, or hire permanent employees, you’ll have to go for other types of financing to sustain these expenditures. Big expenses will drag down your current working capital. It’s best to maintain your working capital for short-term needs rather than large expenses that take time to pay off. 

Giving Your Working Capital a Boost Through Small Business Financing

Understanding your working capital will help you prepare for any situation. It will also keep your business afloat whatever the season is. If you want to add more funds to your working capital, consider getting a line of credit or unsecured loan to boost your potential for more revenues. Be on your way to smart financing by comparing loan options you can make the most out of here


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