What is working capital?
Cash flow and accounting

What is working capital?

Managing working capital is crucial to the success of every business. Sufficient working capital is required to meet the minimum operational costs of business. More importantly, additional working capital is needed when a company is growing. It also allows them to take advantage of new opportunities or short-term investments.

What is working capital?

Working capital describes the funds used to run day-to-day business operations in small businesses. 'Capital' is another word for money, so working capital is the business's money for daily operations.

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Working capital is the heartbeat of any organisation, and it can tell you a few critical things. Firstly, it indicates the financial health or liquidity of the business. It will also tell you if you have enough cash for unexpected expenses and whether you’ve got too much tied up in cash and stocks. Or, most importantly, whether you’re running the risk of becoming insolvent.

In an ideal world, you’d buy something, make something or provide a service one day. Then, the very next day, get paid for it. In reality, businesses usually have to wait for many weeks to see a return on an outlay. Working capital is required to cover this gap and carry on trading as usual.

How to raise working capital finance

Working capital is usually the first thing to be raised when a business starts. There are several ways to raise working capital, including:

  • Borrowing money from a bank, non-bank fintech lenders or other financial institutions
  • Raising equity investment
  • Raise venture capital funding from individuals or other businesses
  • Angel investment
  • Borrowing from friends or family

How to calculate working capital

Working capital is the difference between a business’s current assets and liabilities. Current assets include cash, accounts receivable, inventory and prepaid expenses - anything that can be converted into cash within a year. Current liabilities are bills due within one year (such as credit card debt). Working capital is calculated by subtracting current liabilities from current assets.

Table Example
Assets Liabilities
Bank accounts Accounts payable
Stocks & bonds Payroll
Accounts receivable Tax
Inventory Dividends
Property Overheads
Raw materials Debts (short and long term)

How much working capital should a business have?

After dividing the current assets by current liabilities, you’re left with a ratio. This working capital formula represents company liquidity and the net working capital position of the business. A positive working capital number indicates that the company has sufficient capital to meet its operating requirements and make short-term investments. A negative figure means that they have a shortfall.

Anything under 1 means the business needs to take action to improve the situation. They may need to borrow additional funds. Negative working capital could prevent them from investing in growth initiatives or meeting their current liabilities.

Managing your working capital

Cash flow management means balancing holding too much and too little short-term capital. Working capital will always have a cost attached and, therefore, should be minimised without impacting the growth of a business. Working capital management aims to achieve the right cash flow balance throughout the company. Efficient management of working capital includes:

Table Example
Assets Liabilities
Maintaining an appropriate level of cash or financing facilities, i.e. managing liquidity Maximising accounts payable terms
Minimising the levels of inventory on hand Maintaining appropriate short-term borrowings and financing facilities to meet cash commitments
Minimising outstanding accounts receivables

Management processes for working capital

To properly manage working capital, several management processes must work together:

  • Accurate and timely measurement and reporting of the key variables which affect the overall level of working capital (short-term liabilities and assets, short-term debt)
  • A cash management strategy (e.g. management of cash and financing facilities to provide cash as and when needed)
  • Strategies to manage accounts receivable and accounts payables
  • Inventory management systems to ensure an appropriate level of inventory is held to meet demand without over-investment

The combination of these processes should ensure capital is available to allow a business to meet its commitments. And to give them the flexibility needed to take advantage of opportunities as they arise without over-investing in unproductive assets.

Outstanding debts (receivables) owed has a direct impact on working capital. Therefore, companies must ensure the collection process is well functioning to avoid a long payment receivables period.

Similarly, inventory levels need to be kept at the optimum level to impact working capital positively. Holding too much stock leaves a company vulnerable, with no cash being received for the goods.

Creditors (payables) also influence the working capital. The longer it takes vendors to be paid, the longer the company maintains its working capital. The period between payment to the supplier and receipt of customer funds is called the cash conversion cycle (CCC).

How does the cash conversion cycle affect working capital management?

The cash conversion cycle is a quick way to understand how soon you should see a return on your investments and how long it will take for the money you've spent to come back into the business.

You need first to understand three essential numbers.

  • Inventory days - how long stock is sitting on a shelf. Or how long you've spent making something.
  • Debtor days - how long it takes you to get paid. It's in the interest of any business to minimise this as much as possible.
  • Creditor days - how long it takes you to pay your invoices. Conversely, it's in the interest of the business to maximise this.

How to improve working capital

Various funding sources are available to companies looking to manage their ongoing cash flow. These include:

  • Cash flow lending, including accounts receivable financing
  • Credit cards and overdrafts
  • Bank loan (although long-term debt via business loans using fixed assets is rarely a good idea for day-to-day expenses)

Disclaimer: always refer to professional advice. The information presented here is purely indicative and not intended as advice. Always consult a legal or finance professional.

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