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Working capital is the fuel which runs the business. To ensure business continuity and sustained growth, you need working capital. Not managing your working capital efficiently, will severely impact the day-to-day operations of the business.
In this article, we will learn and understand:
Working capital refers to money available for carrying on the day to day business operations. Working capital represents the financial liquidity of the business. It is often said that the way you manage working capital will make a big difference in the growth and continuity of business.
The concept of working capital includes current assets and current liabilities. The difference between these two is the working capital available for business to fund its daily operations and seed further growth.
To calculate working capital, you need to consider all the current assets and current liabilities of the business. Current assets are those which you can convert into cash in the short-term, usually, 1 year and current liabilities include all short-term debts. Following are some of the major attributes of working capital.
The formula to calculate working capital is given below
Working Capital = Current Assets – Current Liabilities.
Working capital is simply a difference between your current assets and current liabilities. If your current assets exceed current liabilities, it said to have positive working capital. Else, it is negative.
The working capital ratio gives quick insights about the health of the business in terms of ratio. The working capital ratio is derived by dividing the current assets by current liabilities.
Working Capital Ratio = Current Assets/Current Liabilities.
Working capital ratio of above 1 indicates the business has enough cash to pay its short debts. Similarly, a working capital ratio below 1 indicates negative working capital and business is facing some sort of financial difficulties in paying their debts.
The way you manage your working capital will make a big difference to your business. Managing working capital is always a question of sufficient or deficient? As stated above, a positive working capital ratio indicates the business is well-positioned to pay its short-term debts. While a negative working capital reflects the financial difficulties to settle short-term debts.
The high working capital ratio is also not always a good thing for business. This indicates the business has too many inventories and struggling to sell those. It may also indicate the business takes a long time to convert its accounts receivables into cash. It also represents you have extra cash that you should invest in other areas of business. Holding extra by not investing is not a smart decision of your money.
In the end, it all boils down to How much working capital is enough? The need for working capital is directly linked to the growth of the business. You need to answer this question considering serval attributes of working capital discussed above.
You need to be smart in managing the different components of working capital to have a positive impact. There are 3 key things which matter most to have strong working capital. Figure out these things by reading ‘3 Key Areas to Strengthen Working capital of your business’