Working capital may be a simple measure of the health of a business but it is a vital tool that all businesses need to survive. This article outlines exactly the importance of working capital and how it effects your business survival.
What is working capital and its importance?
Working capital is the difference between a business’s current assets and its current liabilities. As such, working capital = current assets – current liabilities.
Current assets are defined as cash plus assets that can be easily and quickly liquidated if required. They can include inventory and accounts receivables (unpaid invoices) with short credit terms.
Current liabilities consist of short-term debts and expenses. They can include employee salaries and accounts payables (bills).
If current assets outweigh current liabilities, working capital is positive. If current liabilities are greater than the current assets, then working capital is negative.
The Importance of Working Capital – What does it says about a business
Working capital is a simple but useful measure that indicates a business’s ability to complete day-to-day operations and by extension, the financial health of the business. For example, positive working capital indicates a business has enough cash or liquid assets to pay for short-term debts as they become due.
Current working capital and changes in working capital give an indication of whether a business can support growth without applying for a loan or other capital-raising initiative.
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What positive working capital says about a business
Positive working capital is usually seen as a good thing because it means a business is able to meet its short-term financial obligations. A business with a very low working capital may be in danger of financial difficulties and a business with a healthy working capital is likely to be financially stable.
That’s not the whole story, however.
If working capital is large, say the value of the business’s current assets is double that of the current liabilities, this is an indication that the business isn’t making the best use of its assets. Such a business is likely inefficient when it comes to converting assets into revenue.
If working capital is positive but declining, that’s another indicator that a business may be heading for financial trouble. Typically, a decline in working capital occurs when sales decrease, however, unsustainable growth and inefficient operations (such as when excess cash is tied up in accounts receivables or unnecessary inventory) can also lead to a decline in working capital. These situations all have negative impacts on a business’s cash flow and financial stability.
A healthy level of working capital varies across industries and between businesses. As an example, seasonal businesses, such as fruit growers and those that provide skiing-related services and supplies, require more working capital during the ‘off’ season.
What negative working capital says about a business
In contrast to positive working capital, negative working capital usually puts a business at high risk of being unable to meet its short-term financial obligations. When a business has negative working capital over a long period, it risks insolvency and bankruptcy.
It’s important to note that a high return or profit doesn’t necessarily equal a good level of working capital. Businesses with great profits may still have a negative value of working capital if they take on a lot of debt to generate those profits.
Working capital also needs to be monitored continuously. As a single measure at one instant in time, it provides limited information about financial health.
Businesses can effectively manage their working capital by:
- identifying day-to-day cash requirements
- shortening the credit terms they offer and negotiating extended payment terms
- constantly evaluating inventory needs and practicing lean or ‘just-in-time’ manufacturing
- obtaining short-term finance (via overdraft, term loan or invoice trading) to boost working capital during times of increased financial liability or decreased sales