What is Working Capital? What is the formula and why it is important

If you’re a small business owner looking to make the most of your financial resources, having an understanding of working capital is essential. Working capital isn’t something that gets discussed much in day-to-day operations, but it’s an integral part of running a successful business. It’s important because managing positive and negative cash flow throughout every stage of growth is vital for keeping your enterprise viable in the long term. In this comprehensive guide, we’ll take a deep dive into why businesses need to understand working capital and how to manage it effectively. You’ll learn about how proper management can maximize your available funds and help you confidently navigate any obstacles as you grow your business further!

What is the Working capital?

Working capital is a financial metric that measures a company’s short-term liquidity and its ability to meet its current obligations. It is calculated by subtracting current liabilities from current assets. Positive working capital means that the company has enough assets to cover all of its short-term debts and liabilities, while negative working capital signals an inability to do so. Businesses must maintain a sufficient level of working capital to pay bills, purchase new inventory and other expenses. 

A company with inadequate working capital may be unable to operate day-to-day activities and even go into bankruptcy. Proper management of working capital helps business owners ensure that their businesses can survive through short-term hardships or periods of slowed growth. 

Why Is It Important For Startups to track Working capital?

Following are the reasons why tracking the Working capital is important for Startups:

1. It helps startups to maintain an adequate level of cash flow: 

The primary purpose of tracking the Working capital is to ensure that the startup has sufficient funds available at all times for its day-to-day operations. Tracking the working capital helps to monitor cash inflows and outflows, which in turn allows startups to make decisions on when to invest and when to save.

2. It helps startups to identify areas of improvement: 

Tracking the Working capital enables startups to find out which areas are not working as efficiently as they should be, such as inventory management or collection processes. This allows them to make adjustments in order to improve their efficiency and profitability.

3. It helps startups to accurately forecast future cash flows: 

By tracking the Working capital, startups can make accurate predictions on future cash flows. This enables them to plan ahead and anticipate potential problems that may arise in the near future.

4. It helps startups to manage risks associated with short-term investments: 

Tracking the Working capital also helps startups to identify any potential risks associated with short-term investments. This allows them to plan ahead and make informed decisions that can help minimize any potential losses.

5. It helps startups to remain competitive: 

Tracking the Working capital also helps startups to remain competitive by giving them a better understanding of their financial position and how it compares with their competitors. This enables them to identify areas for improvement, as well as potential opportunities to take advantage of. 

Overall, tracking the Working capital is essential for any startup business. It helps startups to maintain a healthy cash flow and identify areas of improvement, while also providing insights into future cash flows and reducing their risk exposure.

How To Calculate the Working capital?

Here is the formula to calculate the Working capital:

Working Capital = Current Assets (Net of depreciation) – Current Liabilities

Let’s take a look at an example: ABC Corporation has current assets of $20,000 and current liabilities of $10,000. The working capital for ABC Corporation is calculated as: 

Working Capital = Current Assets – Current Liabilities = $20,000 – $10,000 = $10,000.

Therefore, ABC Corporation has a working capital of $10,000. This means that the company has enough cash and liquid assets to pay off its short-term debts and obligations.

What factors affect Working capital?

The following factors affect Working capital:

1. Business Cycle: 

The performance of the business cycle plays a significant role in determining the amount of Working capital required. During times of economic prosperity, businesses tend to purchase more inventory and increase their accounts receivable, leading to an increase in Working capital requirements. On the other hand, during recessions or downturns, businesses may reduce their inventories and shorten their accounts receivable terms, thereby reducing Working capital requirements. 

2. Business Size: 

Companies with larger operations typically have higher Working capital needs than smaller businesses as they are more likely to have large inventories of goods and a higher level of accounts receivable. 

3. Operating Cycle: 

The operating cycle is the time it takes a business to turn its inventory into cash. The longer the operating cycle, the more Working capital is needed for the business. 

4. Credit Terms: 

Companies that offer their customers generous credit terms will typically have larger accounts receivable balances and therefore higher Working capital needs. 

5. Cash Flow: 

A company’s ability to generate cash flow is a key factor in determining how much Working capital is needed. Companies that generate positive cash flow typically require less Working capital than companies that are generating negative cash flows. 

6. Seasonal Business: 

Companies with seasonal sales cycles may require higher amounts of Working capital to meet their inventory and accounts receivable requirements at certain times of the year compared to others. 

7. Leverage: 

Companies with higher levels of debt or leverage will typically have less Working capital as they are more likely to use external financing sources to fund their operations. 

8. Profitability: 

Companies that are generating higher profits typically require less Working capital than companies that are unprofitable. This is because profitable businesses have access to other sources of funding such as bank loans and equity financing. 

Overall, it is important to understand the factors that affect Working capital and how they can impact a company’s ability to finance its operations. By monitoring these factors, businesses can be better prepared to manage their Working capital needs in order to remain profitable.

What is good Working capital?

Good working capital is a measure of a business’s ability to pay its short-term obligations. It can be calculated by subtracting current liabilities from current assets. A healthy ratio will indicate that the company has enough liquid resources to cover its immediate expenses and adequate funds to invest in future growth opportunities. Companies with weak ratios may struggle to pay their bills on time and may not have enough funds to support future growth. 

Good working capital is important for businesses of all sizes, as it can provide a financial cushion when unexpected expenses arise or if cash flow becomes tight. A good ratio will also indicate that the business is well-managed financially and is able to make timely payments. Additionally, having a healthy working capital position can also help a company gain access to financing and better loan terms. 

A well-managed business should aim for a ratio of 1:1 or higher, meaning that current assets are at least equal to current liabilities. The higher the ratio, the more liquid resources are available for the business to invest in future growth.

Quotes about Working capital

1. “The only way to succeed in business is by having the capital, resources and energy to do what it takes. Working capital is a must.” — Robert Kiyosaki
2. “Working capital is the lifeblood of any business—it’s essential to keeping operations running smoothly.” – Bill Gates 
3. “Proper working capital management helps entrepreneurs reduce costs and increase cash flow, allowing them to make better decisions for their businesses.” – Steve Jobs

What are examples of Working capital?

Tithing Inc. has the following current assets and liabilities listed: Accounts Receivables at $40,000, Cash at $15,000, Inventories at $34,000, Marketable Securities at $45,000 and Prepaid Expenses of $5,000; while their current liabilities consist of Accounts Payables at $35,000, Notes Payables at $15,000, Accrued Expenses of $12,000 and Short term debt at $34,000. 

To find out their Working Capital (WC), we need to add up the total current assets which is ($40,000 + $15,000 + $34,000 + $45,000 + $5000) = $139,000 and total current liabilities which is ($35,000 + $15,000 + $12,000 + $34,000) = $96,000. 

Applying the formula WC = Current Assets – Current Liabilities we get a positive result of WC = $43,000. 

This shows that the Working Capital of Tithing Inc. is healthy.

Example 2:

Our hypothetical company has the following operating working capital line items for 2021: Operating Current Assets: Accounts Receivable = $25 million, Inventory = $40 million, and Prepaid Expenses = $5 million; and Operating Current Liabilities: Accounts Payable = $15 million, Accrued Expenses = $10 million, and Deferred Revenue = $5 million. 

To calculate the operating working capital, we add up each side: Operating Current Assets = $25 million + $40 million + $5 million = $70 million, and Operating Current Liabilities = $15 million + $10 million +$5 million = $30 million. 

Upon subtracting these two values from each other, the operating working capital of our hypothetical company is equal to $40 million: OWC = $70 million – $30 million = $40 million. 

The formula for this calculation can be stated as follows: Operating Working Capital = Operating Current Assets – Operating Current Liabilities. 

This equation will help us determine the current financial health of a company by accounting for all of its current assets and liabilities. We can see this from wallstreetprep here:

Tips to improve the Working capital

The following strategies can help to improve the Working capital :

1. Increase the collection time: 

Companies should try to get cash from customers as quickly as possible. This can be achieved by sending bills quickly, following up on outstanding payments, and offering incentives for early payment such as discounts or other benefits.

2. Reduce inventory holding costs: 

Holding excess inventory can tie up working capital and limit funds available for operations. Companies can reduce inventory holding costs by streamlining their order processes, implementing just-in-time inventory systems, and negotiating better terms with suppliers. 

3. Optimize accounts payable: 

Paying suppliers promptly can help companies maintain relationships and secure discounts for early payment. Companies can optimize accounts payable by negotiating better payment terms, combining payments to take advantage of discounts, and automating payment processes. 

4. Utilize short-term financing: 

Companies can use short-term financing options such as lines of credit, invoice factoring, and merchant cash advances to bridge the gap between payments from customers and payments to suppliers. This can help companies access funds quickly without taking on too much debt. 

5. Improve cash flow forecasting: 

Accurate cash flow forecasting can help companies plan for upcoming expenses and ensure that there is enough capital to cover operations. Companies should review their financial statements regularly, analyze seasonal trends, and use software tools to improve their forecasts. 

6. Monitor working capital ratios: 

Monitoring the current ratio and quick ratio can help companies identify potential issues and take corrective action as needed. Companies should strive to maintain a healthy balance of liquid assets and liabilities. 

7. Leverage technology: 

Technology can help companies reduce costs, automate processes, and improve visibility into finances. Companies should take advantage of the latest tools to streamline operations and free up working capital. 

8.Review and renegotiate contracts: 

Companies should review their existing contracts and look for opportunities to renegotiate terms such as payment schedules, discounts, and delivery times. This can help reduce costs and improve cash flow. 

These strategies can help companies improve their working capital and better manage their finances.

The Bottom Line

Managing your working capital is a challenging but important task for any business owner. By following the tips in this guide, you can ensure that your business has the resources it needs to continue operating smoothly. Remember to keep an eye on both your current and long-term financial needs, and reach out to experts when necessary. With careful planning and management, you can keep your business running smoothly for years to come.