The amount of money used for everyday transactions is referred to as a company’s working capital. A business’s current assets and liabilities should be balanced for it to have enough working capital to sustainably operate and achieve profitability. This is why working capital is so important to businesses; it enables them to pay operating expenses even when economic times are difficult. Consequently, having solid working capital is a sign of a well-run company that should not be overlooked.
The Importance of Working Capital
Working capital is often called net working capital. It is the amount required by the company to finance its day-to-day operations also it represents the difference between a company’s current assets and current liabilities.
Working capital measures, the company’s liquidity and short-term financial health. Positive working capital indicates when its current assets exceed its current liabilities. When a business has excess current liabilities than existing assets called Negative working capital. Negative working capital indicates a sign of insufficient liquidity and poor short-term health.
A high level of working capital is not always positive. It could indicate that the company has too much inventory and isn’t taking advantage of opportunities for low-cost debt.
How to calculate working capital
Working capital is computed as a dollar amount using the formula below:
Working Capital = Current Assets – Current Liabilities
An example of this includes the working capital of $200,000 with a manufacturer, which is calculated by deducting current liabilities of $400,000 from the current assets of $600,000 ($600,000- $400,000 = $200,000).
The working capital ratio shows the amount of working capital available for every dollar of current liabilities.
Working Capital Ratio: The Key Formula
The working capital ratio provides details about your business’s capacity to cover operating costs. It also provides information on the overall state of the business. A higher ratio indicates that there is extra cash on hand, which is usually a good thing. A lower ratio indicates shorter cash, so a slowdown in sales could result in a cash flow problem. A ratio of 1 or below indicates that it will be difficult for the company to cover its present obligations. The working capital ratio is calculated as current assets divided by total liabilities.
Maximizing Your Working Capital Cycle for Business Growth
The period of time (measured in days) taken for a business to convert its net current assets and current liabilities into cash is known as the working capital cycle. The working capital cycle is also known as the operational cycle or cash conversion cycle. It calculates the amount of time that elapses between when you pay for items and when you get payment from clients.
If your operational cycle is lengthy, your capital will be invested and not earn a return for a longer period of time. The working capital cycle’s essential components are:
Money
Raw material/Inventory
Payables (money your company owes to suppliers)
Receivables in Cash (money owed to the company by customers)
Working Capital Management is Essential for Business Success
Working capital is crucial for businesses because it keeps them solvent. In theory, even if a company is profitable, it may go bankrupt. A company must be able to pay its bills immediately with cash; it cannot rely on paper profits to use it. Let’s say a company has $2 million in cash on hand as a result of its retained earnings from previous years. If the company invested the entire $1 million at once, it might not have enough cash on hand to cover its current liabilities.
Understanding Different Types of Working Capital
Working capital can be divided into subgroups depending on the concept and periodicity.
Permanent Working Capital
Regular Working Capital
Reserve Margin Working Capital
Variable Working Capital
Seasonal Variable Working Capital
Gross Working Capital
Net Working Capital
Effective Strategies for Enhancing Working Capital Management
There are some ways to increase Working Capital Management including:
1. Reduce operational cycles by submitting your invoices on time.
One way to improve cash flow is to shorten your operational cycle, which is the procedure for converting funds retained in production and sales into cash. The longer this procedure goes on, the more likely it is that payment won’t be made, which will have a bigger impact on your working capital. Due to delayed invoicing, longer operational cycles may result in lost revenue and bad liquidity.
2. Check new customer’s credit carefully.
Your accounts receivable could be directly impacted by a customer’s poor credit rating. Make sure your clients can afford to pay their expenses. Additionally, consider granting new clients with lesser credit limits until they have established themselves as trustworthy payers.
3. Improved receivables collection
To maximize its receivables, the business should concentrate on the clients who have the greatest ability to pay. Publicly available financial information, such as annual reports, will demonstrate a company’s capacity for repayment to public corporations.
4. Inventory Control
Avoid overstocking your inventory. Ensure that finished goods are sold as quickly as feasible and that they are not sitting in the warehouse. Remove non-performing products and services.
5. Monitor account payments and accounts receivable automatically.
Tracking inflows and outflows is made simple by automation. Make sure your collection staff is capable of pursuing late-paying clients. Reward employees who are successful in collecting dues.
6. Utilize Current Financial Data
Maintain updated financial statements and reports and construct fast ratios on a regular basis. This will offer your organization a comprehensive picture of its financial status at all times, as well as opportunities for improvement.
Negative working capital, on the other hand, is a red flag that a business may be struggling to stay afloat. An ERP with strong compliance management, however, improves business performance and increases financial close efficiency while lowering back-office costs, resolving delays, and producing statements and disclosures that meet regulatory requirements.
Accounting software can help you manage your company’s working capital. Several accounting software options are good and suitable for both small and large businesses. Positive working capital indicates that you have enough liquid assets to invest in growth while fulfilling short-term responsibilities like paying suppliers and loan interest payments.
You can plan and implement accurate business decisions with accounting software such as NetSuite/SAP/MS Dynamics business central for large businesses, and QuickBooks Desktop/Sage Intact/Xero for small businesses.
To ensure your business is viable enough to obtain business financing in the future, IBN Tech experts evaluate what your business needs and where it needs to improve. IBN Tech offers businesses a range of expert bookkeeping and accounting services with 22 years of expertise and has served more than 2,000 clients from various industries. Contact our professionals if you require someone to handle the accounting requirements for your business.
Conclusion
Maintaining specific proportions is important while playing a business game that is advantageous to both parties. In reality, many firms are struggling with cash flow issues and are unable to finance their operating cycles. The working capital ratios are the foundation of any business that shareholders, analysts, or investors rely on.
