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This article is for educational purposes and does not constitute legal, tax, or financial advice. For specific advice applicable to your business, please contact a professional.
You’ve probably heard the saying, “It takes money to make money.” That money is working capital, which is a measure of your business’s financial health. Working capital is the difference between your current assets and your current liabilities. It represents the liquidity you have in your business, which means the ability to pay your bills to cover short-term financial needs and operate efficiently.
When your working capital is positive, it means you have the money needed to meet your liabilities and grow your business. When it’s negative, consider it to be a flashing warning sign of potential financial trouble ahead.
What is working capital?
You need working capital for a few reasons. First, liquid assets (cash or assets that can be easily converted into cash) are critical when it comes to paying your bills. Your creditors and vendors want timely payments. When you have positive working capital, you can feel secure that you’ll have the available funds when bills are due.
Positive working capital also gives you a more significant potential for business growth. Ready cash allows you to expand your product line, fund a new marketing campaign, hire more staff members, or launch a new website. These investments can generate additional revenue.
If your working capital is weak or negative, however, you won’t be able to afford to take these steps, and you may even get behind in your bills. This means you have more liabilities than assets. To meet your current accounts, you may have to sell off assets or obtain funding. Negative working capital can put you at risk of bankruptcy, and it’s often the result of poor cash flow or business management.
Working capital formula
To calculate your working capital, add up your current assets and subtract your current liabilities. This number is your net working capital amount.
For example, if you have $750,000 in current assets and $400,000 in current liabilities, your net working capital amount is $350,000, and your working capital ratio is 1.875.
| Current Assets | Current Liabilities |
|---|---|
| Accounts receivable | Accounts payable |
| Assets for sale | Customer deposits |
| Cash | Expenses such as salary and other costs |
| Inventory | Short-term debts due within 12 months |
| Prepaid expenses | Taxes due |
| Short-term investments | Wages payable |
Working capital ratio and how to improve it
To measure your financial health, calculate your working capital ratio by dividing your current assets by your current liabilities.
A good working capital ratio will depend on your industry. Generally, anything between 1.2 and 2.0 is regarded as being within a healthy range. When you drop below 1.0, you have negative working capital. If your working capital is above 2.0, it may not necessarily be a good sign and could indicate that you have too much inventory or are not investing your extra cash into activities that can generate growth and revenue.
Your working capital ratio is a measure of liquidity, or your ability to meet payment obligations in the future. Going the extra step and calculating your working capital ratio can help you plan ahead for your business.
If your ratio isn’t where you’d like it to be, you can take steps to increase your working capital.
- First, look at your margins. If it’s been a while since you raised your prices or rates, you may be due for an increase. This step can help you earn additional profits.
- Consider replacing your short-term debt with long-term debt. If you qualify for financing, think about a small business loan. Short-term debt is any loan that is payable in less than a year and can include lease payments or accounts payable. Converting these into long-term debts takes them off of your current liability side and boosts your ratio.
- Sell long-term assets that you no longer need. By selling real estate or expensive equipment you no longer need, you can improve your working capital. You’ll not only add funds, you will improve operations by removing related expenses, such as maintenance or insurance.
- Update your inventory. Low working capital can also be a sign of poor inventory management. Get rid of stale inventory by holding a sale or selling it to a liquidation company. This process will also provide information about products or thresholds to adjust in the future.
- Keep an eye on high accounts receivables. If your accounts receivables (the balance of money due to your business for goods or services) are high, you may need to create a better method of collecting your customers’ payments. Consider hiring or outsourcing this task to a CPA or accountant who can help you manage it more efficiently. For delinquent accounts, you may have to hire a debt collector who can recover the funds.
Why you may need additional working capital
Extra cash on hand may be more critical at certain times. If your business has a busy season, you may need extra cash to prepare. For example, retailers often gear up for the fourth quarter or gift-giving holidays with additional inventory or temporary employees. Having extra working capital can also help you meet obligations during slower periods.
Slow payments may also prompt a need for more working capital. The current uncertain economy may have caused some customers to pay their bills late. Instead of being late with payments to your suppliers or lenders, adequate liquid funds on hand can keep you current while you wait for the marketplace to change.
And, sometimes, unexpected business opportunities arise, and having cash on hand allows you to take advantage of them. For example, a supplier may be liquidating inventory or offering discounts for bulk orders. If it’s one of your bestsellers, you can stock up to improve your profit margin.
How to qualify for a working capital loan
One way to increase your amount of working capital is by obtaining funding, such as a small business loan or line of credit. When you apply, lenders will review:
- Net working capital
- Working capital ratio
- Balance sheet
- Bank and income statements
- Annual revenue
- Payment history
- Length of time in business
- Business credit scores (and possibly your personal credit scores as well)
Some lenders may also ask to review your personal finances. The process is meant to measure the lender’s risk in lending you money.
Avoid these working capital mistakes
Working capital is for your company’s short-term financial health and shouldn’t be confused with more permanent needs, such as multi-year loans that help you create a long-term business strategy. You’ll still need to look at a mix of both immediate and future goals for a more holistic business strategy. This is why you might want to consider not using working capital to purchase significant long-term investments. This could put your current obligations at risk for strategies that may not pay off for a while.
By knowing your numbers, you can keep tabs on the health of your business and make changes when needed. Having liquid cash to cover your day-to-day operations, fund growth, and weather a down period can be the difference between thriving and surviving.
