Things to Know Know About Working Capital in Businessby Sanjana Mehta Insurance Advisor
Working Capital is the short term financial health and its liquidity and operational efficiency. In simpler terms, working capital is the difference between a company’s current assets and its current liabilities.
A company’s assets include cash, accounts and unpaid bills from the customers, finished goods and inventories of raw materials. Their current liabilities include debts and accounts payable.
Why is working capital important?
A company has the potential to invest and grow when it has considerable positive working capital. On the other hand, a company might even risk going bankrupt if it has trouble finding or paying back creditors when its current asset fails to exceed its current liabilities.
Terms like these might not crop up in everyday operation of a company, but it is vital to a company’s success. Working capital affects numerous aspects of a business. It comes into play from paying the vendors and employees down to the very core of keeping the business alive and making plans for sustainable long-term growth.
To make working capital favorable to a business, one needs to calculate their current levels carefully, future needed projects and then make sure they have enough cash flow to cover all such costs.
Know How to Calculate Working Capital
One can calculate their company’s working capital ratio with the help of the working capital formula:
current assets/current liabilities = working capital ratio
For example, let's assume a company has assets worth one million dollars and their current liabilities are five hundred thousand dollars. Then their working capital will be at a 2:1 ratio. Even though this ratio is considered healthy, there might be exceptions in some industries and business models, and the 1.2:1 ratio might even be considered adequate.
Know How to Calculate Net Working Capital
Net working capital stands for the amount of money readily available to a business to meet its current expenses.
This is how one can calculate their net working capital:
current assets-current liabilities = net working capital
The current assets in this calculation need to be only the short-term assets like the cash in their business account, the accounts receivable, i.e., the customers' money and the inventory they expect to convert into cash within the next twelve months.
The short term liabilities should include the accounts payable, i.e. the amount of money they owe to the vendors and creditors and other debts, taxes, accrued expenses and other outlays.
Frequent Missteps Regarding Working Capital
Often, business owners get confused with their short-term working capital needs and their long-term permanent requirements.
Though one can’t completely predict how a company will run in the future, one needs to have a clear understanding of working capital in order to help in the smooth day-to-day operation of the business while setting up a long term growth plan.
It might be tempting to use working capital for short-term gains like buying real estate, purchasing machinery, or hiring permanent employees. But one needs to keep in mind that this kind of expenditure needs a different kind of financing. Suppose one ends up tying up their working capital line of credit in these kinds of expenditures. In that case, they will struggle financially to find cash flow where working capital Loans is needed.
It is advisable to consult one’s small business banker. They have a better understanding of working capital and can help understand the working capital needs one has and the right steps needed to prepare for any unforeseen situation.
Reasons for a Business to Need Working Capital
· There are certain seasons, such as a particular festive season of a country or state, when business catering to such locations needs extra capital to prepare for the season’s sales. Or those offseasons when sales are not high, and small businesses need cash flow to sustain through. During such periods, working capital comes in real handy for businesses, especially small businesses.
· There are times when a business is waiting for future payments from customers but needs funds to fulfil their obligations towards the suppliers or employees, pay government taxes, etc. Again, working capital will come to the rescue in such crucial times.
· Working capital can also help enhance one’s business, for example, buying supplies in bulk during discounts offered by suppliers.
· Working capital also comes in handy to cover project-related costs before payments are received or pay temporary employees etc.
Understanding Working Capital Needs
Business owner needs to understand their working capital needs truly. One might have to meticulously calculate their inflow and outflow amount for each and every month separately.
For example, a business that makes face colors like gulal will have a huge inflow of revenue during festivals like Holi. Still, other seasons are not that profitable, or even the inflow of money sometimes falls to zero. But their expenses remain to tick constantly round the year. Such businesses can use working capital well to their benefit.
To calculate such future income and expenses, one can look through the company’s past ledger, though sometimes one does need to make some educated guess. One also needs to understand the expected future projects or keep room for unforeseen expenses.
It is advisable to consult an expert like a small business banker to get a clear picture of the working capital one’s business needs and how to use it to the fullest.
Created on Jan 6th 2022 01:26. Viewed 255 times.