What Is Working Capital & Why Is It Important For My Small Business?
There’s a wide variety of types of working capital, from initial working capital to permanent working capital, reserve margin working capital, and more. Here, we are going to focus on regular working capital.
The SBA’s definition of regular working capital is that it’s the money used to handle everyday expenses, so it’s essential to any successful business. You must have enough capital on hand to run your daily operations, but you don’t want to leave money just lying around; it’s crucial to invest money back into growing your business, after all.
For some businesses, simply understanding the working capital equation and reducing unnecessary expenses are the keys to proper working capital management. For other businesses, working capital loans are the only way to maintain consistent cash flow.
What exactly is working capital, and what is it used for? Let’s dive in.
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What Is Working Capital?
You might be more familiar with the term operating capital vs. working capital, but these are just different terms for the same thing. Working capital is the difference between your current assets and your current liabilities. Essentially, it’s the amount of operational liquidity you have.
For definitional purposes:
- Current Assets: This includes cash on hand and any assets that will become liquid by the end of the fiscal year. Assets that could become liquid later in the year include such things as inventory that’s set to move and accounts receivable.
- Current Liabilities: Debts owed by a business that must be paid within the next twelve months, including accounts payable, overhead, and debts, such as short-term loans.
The biggest point of confusion regarding working capital comes from the fact that your current assets include cash and non-cash assets. While both factor into your working capital calculation — it’s assumed assets such as unpaid invoices will soon become liquid — you’ll also want to know how much working capital liquidity you have. Your working capital liquidity is simply the amount of your working capital that is currently cash.
Now let’s look at what all this means in practice.
Why Working Capital Matters
Working capital represents your spare capacity (or lack thereof) to take on additional expenses. If you have $5,000 in working capital, that demonstrates that you can pay off your business’s debts and still meet the expenses your business needs to continue running. If your working capital is negative, that indicates that you will have a hard time servicing all of your expenses and might be a poor candidate for a loan.
Even if you aren’t looking for a loan, knowing your working capital numbers can give you a sense of whether you’re efficiently using your revenue or at risk of going into debt from a small disruption.
The Working Capital Formula
The formula for working capital is very simple:
Current Assets – Current Liabilities = Working Capital
For example, let’s say your business’s current assets and liabilities look something like this:
|Current Assets||Current Liabilities|
|Accounts Receivable||$3,000||Credit Card||$1,000|
Your total current assets come out to $10,000, your current liabilities to $8,000. Your working capital would amount to $2,000 ($10,000 – $8,000).
Remember, not all of your current assets are in the form of cash. In the example above, you have $10,000 in current assets, but only the $2,000 cash is readily accessible. You also have $5,000 in inventory, so you won’t get those funds until customers purchase the items, and $3,000 is in accounts receivable, meaning you won’t get the funds until your customers pay their invoices.
It’s important to keep working capital liquidity in mind to know how much of your working capital is actually available for you to use immediately.
What’s A Good Working Capital Ratio?
There’s another simple formula you’ll want to be familiar with, and that’s your working capital ratio. While it’s impossible to boil down all of the complexities of a business into a single number, your working capital ratio can be used as a rough estimation of your company’s overall health.
Working Capital Ratio = Current Assets / Current Liabilities
Going back to our previous example, we can divide our assets by our liabilities to get our working capital ratio, $10,000 / $8,000 = 1.2. Generally speaking, you want a working capital ratio somewhere between 1.2 and 2.0. If it’s below 1.2, you may have trouble getting financing. If it’s above 2.0, you may not be utilizing your assets efficiently and may not be growing at the rate you could be.
How To Improve Your Working Capital
Since your working capital is based on two oppositional values — current assets and current liabilities — you can affect your working capital outcomes by changing your current assets or by changing your current liabilities. Many businesses will want to increase their current assets and/or reduce their current liabilities to raise the amount of working capital they have. But remember, having too high a working capital ratio means you’re probably not using your capital efficiently, so in some cases, you may want to do the opposite.
There are many different ways to improve your working capital ratio, but many fall under the umbrella of improving your business’s efficiency. This includes investing in better inventory management, implementing policies that encourage receivables to be paid on time, cutting waste, and improving cash flow. Depending on your business, this may be a trivial or intensive task.
And if you’re looking for information about working capital loans, check out our list of the best working capital loans.