What is working capital?
Working capital is the difference between a business’s current assets and current liabilities. This doesn’t include fixed assets, which are illiquid and can’t be easily converted to cash.
Your company might use working capital to pay for short-term obligations and invest in growth. Say one of your clients orders a big project — but you need to hire temporary workers or buy extra supplies to complete the project on time. If you have sufficient working capital, you can afford these short-term costs, take on the project, and, ideally, impress your client and get more business from them in the future.
If your business always has positive working capital, you can jump on opportunities like this. You can also cover operational costs when you face short-term financial challenges, such as late payments from clients.
The important thing to remember with calculating, tracking, and using working capital is that you’re looking at current assets and current liabilities because you want to know how much capital you have to work with now. It’s not money for future needs.
Working capital vs. equity
Both working capital and equity reveal information about a company’s financial health by comparing assets and liabilities, so it’s easy to confuse them. However, working capital doesn’t include the value of assets that can be sold. Equity does.
Equity looks at the difference between total assets and liabilities from the company’s balance sheet. If your business has $10,000 in your bank account and your current liabilities total $6,000, you have a positive working capital of $4,000.
But investors want to know your company’s value if you sold off all your assets — and that’s the equity.
Three components of working capital
Effective working capital management will help your company ensure there’s always money available for navigating the ups and downs of running a business. If your business runs into the negative working capital territory, it could struggle to pay its day-to-day expenses.
On the other hand, if your business is sitting on a large pile of cash all the time, that might indicate you aren’t using your resources wisely, which could stifle growth. Here’s an overview of the three main components of working capital management you should track.
Accounts receivable
Your accounts receivable account is the money that customers and debtors owe to your business. When you bill a customer for a service you provided and give them a due date at the end of the month, you can reasonably expect to receive revenue by the bill’s due date. That revenue is part of your accounts receivable for the month.
If your company has enough cash, accounts receivable, and other current assets to cover its short-term obligations (such as accounts payable and short-term debt), it has positive working capital. By tracking your accounts receivable, you always know how much money you have coming in from pending invoices, which can help you better manage your working capital.
Accounts payable
Accounts payable is the money your business owes suppliers and creditors. Think of subscription payments for goods or services and supplies you buy on credit.
Businesses might hold off on paying suppliers while waiting for receivables to come in to maximize cash flow. However, this can impact supplier goodwill without actually increasing working capital.
A better strategy is to ask vendors for discounts or rebates for on-time payments and bulk purchases. This is where tools like accounts payable automation come in. With an AP system that simplifies the approvals process and ensures timely payments, you build stronger supplier relationships and are better positioned to negotiate prices.
The more refined your accounts payable (AP) process, the more strategic your business can be about managing this side of the working capital equation.
Inventory
Inventory refers to all the merchandise, materials, and other goods a business holds to sell in the market to earn a profit. Because inventory is typically converted into cash within 12 months, it’s considered a current asset.
For example, a flower shop offers delivery to its customers. The flowers are part of the shop’s inventory, but since the delivery van is not a current asset, it’s not included in the working capital.
A large inventory will mean a large amount of working capital, but that doesn’t mean your business has enough liquidity to pay the bills. That’s because inventory isn’t a quick asset, unlike cash and accounts receivable. It can take months to turn inventory back into cash and replenish your business checking account.
You can understand how quickly your business moves inventory with expense tracking. And with expense management software, you can track cash as it moves through the operating cycle, from cash to inventory and back into your bank account.
Ultimately, if your business does a good job at managing money going in (accounts receivable) with money coming out (accounts payable) and inventory, you should always have enough to pay the bills.
Why do businesses need working capital?
Working capital is for covering short-term obligations. But by doing that, your business can use it as a tool for success. Here are some ways your business can use working capital to help it thrive — in good times and in bad.
Reason #1: Healthy working capital means you can invest in opportunities
- No matter what industry you’re in, opportunities always crop up. But you have to be ready to take advantage of them, and that’s where working capital comes in.
- The owner of a pizza food truck notices that a tri-state festival is taking place in a nearby town. The pizza shop uses its liquid assets to buy a spot at the festival, stock up on inventory, and hire temporary staff to increase production during the festival.
- A mortgage company notices that interest rates are dropping, so it invests in a short-term marketing campaign to attract the expected increase in homebuyers.
- A vegetable farmer learns about a new supplier, so they buy in bulk now to reduce their overall supply costs.
New projects, an increase in demand, a research opportunity — whatever it is, if it can help your business increase revenue, you want the flexibility to dive in. And without adequate working capital, you’d have to watch these opportunities pass by.
Reason #2: Working capital helps manage expenses while waiting for payments from customers
Unfortunately, customers don’t always pay on time, and late payments impact small businesses. But businesses can use their working capital to cover operational expenses, pay suppliers, pay a tax bill, or meet other short-term obligations while waiting for money owed to come in.
Not only can you pay the bills, but you’re also avoiding taking on short-term debt and decreasing the amount of working capital you have. If you don’t have liquid assets, your business would have to buy on credit.
In short: When you have enough working capital and keep replenishing it, you’re less likely to fall into a hole you can’t climb out of.
Reason #3: Working capital can attract funding
Investors and lenders might look at working capital to understand a business’s financial health. A large amount indicates a business can meet all its short-term obligations. It also says a lot about how efficiently it runs.
However, negative working capital or low working capital isn’t necessarily a bad thing. Larger corporations might have negative working capital because they have large short-term debts. But for small businesses on a growth path, ensuring you have plenty of working capital is important.
How to calculate working capital
As a business owner, you should track your working capital so you know how much you have to work with and can make changes to adjust it if it’s not where it should be. With that said, there are two main formulas: The net working capital formula and the working capital ratio formula.
Method #1: Net working capital formula
This formula shows you your net working capital (the available amount). Remember that your net working capital isn’t necessarily highly liquid: If you have a high inventory, some of your money could be tied up in merchandise you need to sell.
Here’s the net working capital calculation:
Current assets – Current liabilities = Net working capital
Your current assets are all short-term assets, like account receivables, the inventory you will sell and convert into cash over the next 12 months, and cash. Current liabilities include short-term debt and accounts payable.
- Cash: $3,000
- Accounts receivable: $800
- Inventory: $1,000
- Current assets: $4,800
But you also owe suppliers $1,200, and your short-term debts (debts you have to pay in the next 12 months) total $2,000.
- Accounts payable: $1,200
- Short-term debt: $2,000
- Current liabilities: $3,200
That means your net working capital is $1,600. That’s a low number, but depending on your business’s needs and how liabilities compare to assets, it might be plenty.
Method #2: Working capital ratio formula
To give your capital amount more context, you want to look at the relationship between your short-term assets and liabilities. That’s where the working capital ratio is applicable. The ratio is an indicator of short-term financial health.
Generally, a ratio between 1.5 and 2 indicates a company is on solid financial ground. It has enough to cover short-term expenses and isn’t at risk of being unable to pay its current debts. A number less than 1 is a red flag that a business might struggle financially or face problems soon.
Here’s the working capital ratio formula:
Current assets/current liabilities = Working capital ratio
In our example, the ratio is 1.5, so the business is in good shape! Learn more about debt-to-equity ratios.
Ways to increase working capital
For a small business, maintaining enough liquidity can be challenging. But because you’ll need working capital for growth, increasing your short-term capital is essential if your ratio is low.
Say you calculate your ratio and discover it’s 0.7. That’s not a good sign, especially if you’re running a small business and trying to grow.
Getting financing might not be accessible when you need a business loan. You also won’t have the flexibility to go with the flow, whether you want to spend money on an opportunity to increase revenue or need to cover expenses until more money comes in.
Fortunately, there are a few ways to increase your company’s working capital.
Step #1: Incentivize customers to pay on time
One way to generate enough cash is to encourage customers to pay on time. You might include late charges for overdue invoices or use a system to streamline your invoicing process and automate payment reminders. (This step may also help you improve your cash flow!)
Step #2: Reduce your business debt
Although credit cards can offer great benefits like rewards and cash back, they may also increase your business expenses from incurred late charges and interest fees. Try to pay down short-term debt faster whenever you can, and you’ll still be able to reap those benefits.
Step #3: Improve your cash flow
Look at how you can increase cash flow to your business. Ask yourself questions like:
- Can you save money by switching suppliers or asking vendors for discounts?
- Does your business credit card offer rewards, incentives, or cash back?
- Can your customers pay online?With expense tracking, you might also spot areas where your business can cut back and save money without impacting your production and profitability.
Get more out of your working capital with BILL
As a small business owner, you should always look five steps ahead financially, and ensuring you have enough working capital is a big part of that. With the right tools, you can track expenses and get more control over your business’s financial situation. That’s where BILL comes in: BILL helps small businesses manage money — all in one place. Learn more about how instant visibility can help your business grow.
