Working capital is simply the amount of money that a business has to operate with. It is the current assets minus the current liabilities. Current assets include cash on hand, inventory and accounts receivable. Liabilities include accounts and notes payable, expenses, and current loan/debt payments.
Working capital represents the liquidity of a company, a measure of its value, efficiency or stability (depending on how you want to look at it).
Working capital is important primarily because it is the money that keeps a business running. With little working capital, a company won’t . . . work. Here are some of the ways that working capital is the lifeblood of a business.
1. Strengthening Solvency
Solvency is the measure of how much greater your assets are than your liabilities; it tells you how easily you can pay off your debts. Having sufficient working capital is the first and best way to pay off short-term liabilities. When you are able to easily pay salaries, equipment rentals, and other immediate costs, then your company can run more smoothly.
2. Moving Forward
One of the most effective ways to propel your business forward is with the use of working capital. When you have the right amount of disposable working capital, you can easily pay off any debts or costs and focus on investing for future expansion. Negative working capital (i.e. a situation where your liabilities are greater than your assets) means that you do not have the capacity to expand.
3. Developing Relationships
When a business is able to make all its necessary payments in a timely manner, it breeds trust and goodwill among its employees, with its vendors and other external agents. With sufficient working capital, a business never has to worry about running afoul of someone to whom it owes money.
4. Improving Health
Working capital can tell you how healthy your company currently is. The current liquidity of a business, also the net working capital, is one of the most important determinants of its health. Liquidity tells investors how easily a company’s assets can be converted into cash. As the amount of money available for day-to-day operations, working capital is intimately tied to liquidity and how easily work can get done in the business.
5. Getting Loans
Every business owner hopes to be able to expand his or her business. In cases where large expansions are planned, a loan may have to be taken out. When a business has good solvency and credit, it is more likely to be approved for a loan. Good working capital, therefore, helps you not only expand using your own resources but also helps you find external funding for expansion.
6. Handling Crises
Any business is likely to face a crisis at some time in its life. How these crises are handled depend largely on the working capital available to the business. Firms with good working capital are able to absorb blows to their revenue stream and keep moving forward.
Make Working Capital Work for You
Working capital is either expressed as a money value (assets minus liabilities) or as a ratio (assets over liabilities). Any business should aim for at least a working capital ratio of 1.2. Whether your company is just getting off the ground or has been operating for decades, managing working capital is key to its profitability.
Managing working capital is an important skill to have. As we have seen, a company’s working capital is one of the most important pieces of information to know regarding its current health and future profitability. Managers who understand working capital and how to use it stand poised to leverage its many benefits to increasing profits.