If a small business is meeting or surpassing its sales goals and acquiring new customers on a weekly basis, it must be doing well financially, right? The answer to this question is “yes,” so long as the business has enough cash in the bank to cover the costs of its short-term expenses and other financial obligations. This cash is known as working capital, and it holds the key to any company’s immediate and long-term success.
You probably do not think about working capital that much, and you might not be entirely sure how important it is, or how to calculate it. This Balboa Capital blog post, titled “What is Working Capital?” has all of the information you need. After reading it, you will have a better understanding of working capital, and how it can help your small business move in the right direction.
Measuring your company’s financial health.
Being able to pay your bills when they are due, and having cash readily available to put back in your business, are signs that your company has good financial health. This also shows that your business is operating efficiently and profitably and, as a result, is less vulnerable to losses that can result from slow sales periods or unexpected economic downturns. In short, the more working capital you have, the healthier your business will be.
Here is an example: A ski resort experiences a big increase in business during fall and winter. Consequently, the ski resort will see higher expenses when compared to the off-season when business is slow. The cost of energy, inventory, foods and beverages, ski and snowboard gear, and employee payroll will all increase. However, the ski resort manages its finances well and rarely experiences working capital shortfalls. That means the resort is in good financial health and ready to weather the busy winter months without tapping into its cash reserves.
How to calculate working capital.
Working capital is one of the easiest business-related figures to calculate. All that you need to do is subtract your company’s current liabilities from its current assets. You can find your liabilities and assets listed on your balance sheet. Liabilities are short-term debts that you need to pay off within the next twelve months, such as credit card balances, short-term business loans, and payroll taxes. Assets are items of value that your small business owns or benefits from, such as working capital, equipment, and inventory.
To illustrate the formula, let us say that the ski resort has current assets of $300,000 and current liabilities of $150,000. Subtracting the liabilities ($150,000) from assets ($300,000) is $150,000, which is the amount of working capital the ski resort has.
The working capital ratio.
With proper financial planning, your small business can eventually have more cash and short-term receivables than short-term debts, which enables you to pay off your liabilities and save for the future. This is referred to as “positive working capital.” On the other hand, if your small business owes more money than it currently holds, or that is coming in from sales, it has “negative working capital.” Calculating your company’s working capital, which is outlined in the section above, provides valuable insight about your company’s financial health. You can take your analysis a step further by calculating your working capital ratio.
Most tax advisors and accountants agree that a healthy working capital ratio falls in the 1.2 to 2.0 range, and that anything below 1.0 indicates negative working capital. To calculate your working capital ratio, you need to divide your current liabilities from your current assets. For example, if your business has $1 million in assets and $500,000 in liabilities, your working capital ratio is 2.0 ($1 million divided by $500,000).
If your ratio is above 2.0, you do not have much to worry about. However, a higher ratio might suggest that you are being too conservative and not maximizing the use of your assets. If you have a ratio of more than 2.0, consult with your tax advisor or accountant to determine what actions should be taken, if any.
How to increase your working capital.
Selling more products or services and generating additional profits is the preferred way to increase your working capital. However, that is easier said than done. To boost your working capital and liquidity, you need to closely monitor many aspects of your company’s financial structure, and make sure you are doing everything possible to maintain a positive cash flow. Common strategies include reducing or consolidating debt, improving your inventory management system, and working with vendors and suppliers who offer special discounts.