What is Working Capital?

What is Working Capital?
Understanding working capital is key to managing your business’ cash flow and making significant purchases to help your business grow.
by Square May 17, 2021 — 4 min read
What is Working Capital?

This article is for informational purposes only and does not constitute legal, accounting, or tax advice. For specific advice applicable to your business, please contact a professional.

Understanding working capital is key to managing your business’ cash flow and making significant purchases to help your business grow. Having a healthy working capital ratio also provides a financial buffer for when things don’t go as planned. Here we outline what working capital means and how to manage it for business success.

What does working capital mean?

Working capital is defined as the difference between your current assets and liabilities, usually within the timeframe of 12 months. It’s the leftover available money you have once you are current on all your accounts and when all money owing to you is paid. This is the money that’s used to operate your business day-to-day, from paying subscriptions to purchasing supplies.

But as well as cash, operating working capital includes assets that can be quickly converted to cash. These types of capital are:

How to calculate your working capital

You can easily calculate your working capital using the following equation:

Current assets – current liabilities = working capital

‘Current assets’ are listed in the types of working capital above, and ‘current liabilities’ means the costs you owe soon – think short-term debt payments from a small business loan and accounts payable (eg. a bill).

If your business has more current assets than current liabilities, you are working capital positive and your business has enough working capital to keep operating. A healthy working capital ratio is somewhere between 1:1 and 1:2, where 1:1 would mean you’re just able to meet short term payments and 1:2 may mean you’ve got more cash in your bank account that necessary – the excess may be better invested in increasing marketing spend or bringing on another employee.

Working capital management tips

Tightening up your cash flow and keeping a close eye on your inventory are the best ways to increase your operating capital. Cash flow measures the ability to generate cash over a specific period, whereas working capital is a snapshot of a present situation. Improving your cash flow will mean you’re well placed in any given moment to have the cash on hand needed to cover hefty expenses, planned or not.

There are three key tactics to increase your working capital:

1. Stay on top of your cash receivables

Communicating with your customers about how you expect to be paid, and what will happen if they pay late, is the first step to improve your likelihood of being paid on time.

2. Slow down your cash payables

Take advantage of credit and payment terms so you can hold as much cash as possible in your account at any time.

3. Manage your inventory

Inventory ties up significant cash for many businesses, so it’s essential to have enough inventory to meet customer demand without having too much stock sitting on shelves (meaning you can’t spend on other things).

Consider working capital loans

If your operational working capital is slim, it could be worth looking into small business loans such as Square Loans to help you manage your cash flow and position your business to prepare for growth. Some businesses have significant inventory payments (due to high minimum orders), long production lead times (if they have overseas suppliers) or fluctuating sales seasons (resulting in payment delays).

Loans are useful to increase working capital at vital times, like in the lead up to busy periods to maximise sales potential. Loans can then be repaid once payments from sales are realised.

Understanding your own business’ working capital finance may take a bit of work to figure out, but when you do you’ll be better placed to manage and grow your business – and be more financially ready for unexpected events!

Square
The Bottom Line is brought to you by a global team of collaborators who believe that anyone should be able to participate and thrive in the economy.

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