Small BusinessOperationsFunding

What is working capital and why is it important?

Picture a bustling e-commerce fulfillment center brimming with inventory and employees, expanding at a rapid rate. But there's a problem lurking beneath the cardboard boxes and packing tape because the business is running low on cash.

Without enough funds to cover its daily expenses, the company could quickly grind to a halt, unable to pay suppliers or staff. This is where working capital comes in — think of it as the fuel that keeps the engine running. It’s the key to help guaranteeing a business can keep the lights on, meet its financial commitments, and take advantage of growth opportunities.

Whether you're a small startup or an established operation, managing your working capital effectively is critical to long-term growth and success. Read on as we dive into common questions like “What is working capital?” and “Why is working capital important?”

What does working capital mean?

Working capital is the difference between a business's current assets (e.g., cash, accounts receivable, and inventories) and current liabilities (e.g., accounts payable and short-term debt). It’s an essential financial metric that helps ensure a company has enough resources to manage its day-to-day operations and short-term financial obligations without interruption.

Understanding your business's cash flow and possible need for working capital begins with a total accounting of assets and liabilities, including:

Paying bills

Every business faces the ongoing challenge of paying bills on time. Whether it's utilities, rent, or service fees, managing these expenses is essential to maintaining operational stability and avoiding late fees or service disruptions.

For example, a restaurant must handle regular payments for its utilities and food supplies so it can serve its customers without interruption.

Payroll

Unless you're a solopreneur, payroll probably takes up one of the biggest chunks of your company’s cashflow. Making sure that employees are paid accurately and on time keeps morale high and operations smooth.

Maintaining inventory and supply levels

A well-stocked shelf is a sign of a well-run business. Effective inventory management allows you to meet customer demands promptly without tying up too much capital in unsold stock, which can lead to high storage costs.

A car manufacturer, for instance, balances maintaining an adequate supply of components to meet production schedules while avoiding excessive inventory that can strain finances.

Covering other necessary operating expenses

Keeping the lights on isn't just a metaphor in the business world. Covering essential operating expenses such as rent, utilities, and marketing is the cornerstone of daily business functionality and growth.

Take a tech startup, for example. Their necessary operating expenses will include investments in cutting-edge software and aggressive marketing campaigns to carve out a space in a competitive market.

Investing in growth opportunities

Strategically reinvesting working capital into new projects, equipment, or markets can catalyze expansion and can increase profitability.

For example, a small bakery may leverage surplus funds to expand its production capacity, illustrating how working capital can be directed toward scaling operations and exploring new growth opportunities.

How to calculate the working capital ratio within your business: working capital formula

To calculate your working capital ratio, simply divide your company's current assets by its current liabilities.

Let's say an e-commerce store has $50,000 in assets and $25,000 in liabilities. The store's working capital ratio would be 2, since working capital = $50,000 / $25,000 = 2.

To calculate the net working capital, subtract all current liabilities from all current assets. In this example, the store would have $25,000 in working capital readily available.

The working capital ratio can be helpful in providing insights into your company's liquidity and operational efficiency. That said, the ideal ratio can vary depending on the industry and a company’s circumstance.

Typically, a working capital ratio of 2:1 or higher is considered ideal, indicating that a company has enough current assets to cover its current liabilities twice over. A working capital ratio below 1:1 is generally considered low and could be a red flag for investors or creditors.

Strategies for managing working capital

Effective management of working capital is a necessity for maintaining business health and agility. Use these strategies to help optimize your working capital:

  • Inventory management. Keep your stock lean and mean. Efficient inventory management helps allow businesses to free up working capital by minimizing unnecessary expenditure on excess stock. For instance, a retail clothing store might use just-in-time inventory strategies to order stock closer to demand periods, reducing storage costs and the risk of overstocking.
  • Optimizing payment terms. By negotiating shorter payment terms with customers and extending payment terms with suppliers, businesses can help ensure a more consistent cash flow and readily available working capital. For example, a manufacturing company might negotiate to receive payments within 30 days from customers while settling supplier invoices in 45 days.
  • Financial planning. Developing robust strategies for forecasting and managing cash flow and allocating resources efficiently can help significantly enhance a business's ability to manage its working capital. This might include regular financial reviews to anticipate cash shortages and surpluses, allowing for timely adjustments in spending and investment.

Risks and challenges of high or low working capital

Running a successful small business requires a savvy balance of resources. Understanding the implications of both low and high working capital levels is one of the first steps to maintaining business stability and growth.

Low working capital

If the working capital ratio is less than one, it means the company's current assets may not be enough to cover its current liabilities.

In other words, it suggests the company may be facing financial difficulties in the short term, such as struggling to pay bills, meet payroll, or make other necessary payments.

Low working capital often leads to liquidity shortages, making it difficult for businesses to cover operational costs like paying suppliers. This can harm supplier relationships and disrupt the supply chain. A lack of sufficient funds may also leave a company unprepared for unforeseen expenses or unable to pursue expansion opportunities when they arise.

Luckily, there are plenty of solutions, including:

  • Increase funding. Consider securing short-term loans or lines of credit to bolster cash reserves. Learn more about funding opportunities.
  • Improve collections. Accelerate accounts receivable by offering incentives for early payment or enforcing stricter payment terms.
  • Reduce costs. Identify and cut unnecessary expenses or renegotiate supplier contracts to reduce outgoing cash.

High working capital

A high working capital ratio means a company has a surplus of current assets compared to its liabilities.

If the result is significantly higher than two, it suggests the company may be holding more cash than it needs, which may be better spent on growth and investment opportunities.

Keep in mind that more isn't always better – while having excess working capital might seem like a safe position, it often indicates that resources are not being utilized effectively. This could mean that capital is tied up in unsold inventory or that receivables are collected too slowly, both of which can dilute cash flow and reduce overall profitability.

Help manage your high working capital by:

  • Seizing growth opportunities. Use excess funds to expand operations, enter new markets, or increase marketing efforts to drive sales.
  • Optimizing inventory. Implement inventory management solutions to reduce excess and improve turnover rates.
  • Exploring new investments. Explore investment opportunities that could yield higher returns, such as upgrading technology or acquiring strategic assets.

Components of working capital

The main components of working capital are typically listed on a company’s balance sheet. Here are some of the biggest line items.

What are current assets?

Current assets are either cash or can be converted into cash within a year, including:

  • Cash and cash equivalents
  • Accounts receivable
  • Inventory
  • Prepaid expenses
  • Short-term investments

Cash and cash equivalents

Cash and cash equivalents are the most liquid components of working capital, encompassing all cash on hand and short-term investments that can be quickly converted into cash. This represents the funds immediately available for use in daily operations, emergency needs, or quick investment opportunities.

Accounts receivable

Accounts receivable represent the money customers owe a business for goods or services already delivered but not yet paid for. Efficient management of accounts receivable means that the company can convert sales into cash without significant delays.

Inventory

Inventory encompasses all the goods and materials a company holds for the purpose of resale and production. Effective inventory management – not too high to incur carrying costs, and not too low to prevent sales – is essential for maintaining a healthy working capital.

What are current liabilities?

Current liabilities refer to a company's financial obligations that are due within one year or less. Examples that may appear on a balance sheet include:

  • Accounts payable
  • Short-term loans
  • Taxes payable
  • Unearned revenue
  • Accrued expenses

Accounts payable

Accounts payable include funds a company owes to suppliers for goods and services received that have yet to be paid for. This is a critical part of working capital management, as negotiating longer payment terms without accruing penalties can significantly enhance a company's liquidity.

Accrued expenses

Accrued expenses are costs that a company has incurred during a financial period but has not yet paid by the end of that period, which can include salaries, rent, utilities, and other operational expenses. Properly managing these expenses helps maintain a healthy cash flow and working capital balance.

Interest payable on loans as well as loan principal due within one year

Debt today can drain tomorrow’s opportunities. Interest payable and the principal of loans due within a year are crucial considerations for working capital. These obligations impact the available cash flow and require careful planning to ensure that they do not disrupt the financial stability of the business.

Why might your business benefit from additional working capital?

Working capital can help keep your operations running smoothly and help allow you to invest in growth. But there may also be other times when your business requires more capital.

Some of those instances could be:

  • Paying bills and/or unanticipated expenses. For example, if a crucial piece of equipment suddenly breaks down, having accessible funds can mean the difference between a minor hiccup and a major operational disruption.
  • Managing inventory. Effective inventory management requires investment, particularly in businesses where product demand fluctuates. Adequate working capital helps allow a company to purchase inventory in optimal quantities, balancing cost-efficiency with the need to meet customer demand without delay.
  • Managing busy seasons, such as during the holidays. During peak periods, businesses often need additional resources, such as seasonal inventory or extra staff to handle fulfillment and pesky “Where’s my order?” messages. Increased working capital during these times can support expanded operations, helping allow your business to capitalize on increased customer demand and maximize profits.
  • Taking advantage of an unexpected business opportunity. Sometimes, opportunities arise unexpectedly, such as a favorable deal on bulk inventory or a chance to expand into a new market. Adequate working capital can help provide the flexibility to seize these opportunities quickly, potentially setting the stage for significant business growth.

Fortunately, there are small business loans that can help you manage working capital. Learn more about short-term loans for small businesses designed for this, including working capital loans.

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