Working capital is the cash available to meet current or short-term obligations. For companies of all sizes, working capital is the means in which day-to-day operations are funded.  Learn more about the importance of working capital from our quick guide!

A working capital definition that makes sense

Working capital is one indicator of a company’s financial health in the short term. It is also called net working capital (NWC) because it is the amount left after the company’s current liabilities are deducted from its current assets. 

Current assets include cash, assets convertible to cash, outstanding invoices, stock inventory including raw materials and items in various stages of production, prepaid expenses, and short-term investments such as government bonds, treasury bills, and high-yield savings and money market accounts.

Current liabilities include supplier payments and other accounts payable, notes payable, dividends, rent, wages, outstanding expenses, and taxes on payroll, sales, and income.

To succeed, a business owner must manage working capital effectively and keep it in a healthy position for short to long term periods. A consistently positive net working capital will allow a company to continue operations even when the economy slumps, and take advantage of growth opportunities when they come up.

A working capital formula that makes it easy to understand your cash flow

Effective working capital management begins with three formulas:

  • Net working capital = Current Assets – Current Liabilities
  • Working capital ratio = Current Assets / Current Liabilities
  • Working capital cycle (in days) = Inventory Days + Receivable Days – Payable Days

These formulas give you a three-dimensional picture of how your company is currently doing financially by telling you how much you have left, how well you can manage your liabilities, and how much you still need.

Although cash flow is computed according to a different set of formulas, the net working capital and working capital ratio formulas can give you a fair idea of what your cash flow looks like. Generally, a positive net working capital could indicate that your cash flow is good. 

Another Key Performance Indicator (“KPI”) to consider is the working capital ratio, which evaluates your company’s capacity to clear its current liabilities with its current assets.

If the assets to liabilities ratio is high (1.2 to 2 is ideal), it could indicate that your business’s current assets are more than enough to settle the current liabilities. If it’s low, especially if the ratio is less than 1, you could have liquidity issues. But a ratio higher than 2 is also not good. It could indicate that your company has too much cash and has failed to reinvest in the business.

In addition to calculating net working capital and working capital ratio, you’d be well advised to evaluate your working capital’s components to see exactly where the positive or negative numbers may be coming from. Net working capital and cash flow don’t always have a straightforward relationship.

For instance, if your positive NWC and high working capital ratio are due primarily to your more liquid assets, then you can indeed say that your cash flow is good. Your liquid assets bring in cash which you can then use to pay off your liabilities. 

But if the positive number comes primarily from outstanding invoices or non-moving inventory, then you may not have the ready cash you need to settle liabilities or sustain operations.

On the other hand, high incoming cash flow does not necessarily translate into positive net working capital. Suppose your company generated its cash flow primarily by taking out a sizable loan or investing in something that may not survive a downturn in sales. In that case, the liabilities could outweigh the assets, resulting in a negative NWC.

The third dimension of your working capital, the operating cycle, also bears looking into. The term refers to the gap between when your company pays its suppliers and when it recovers its expenses through revenue from products sold or services provided. 

Once you’ve calculated your business’s operating cycle, determine your working capital requirement, the amount of money you will need to continue operations within that time gap. Is your company’s cash flow sufficient to bridge this gap? Or should your company improve its working capital management to generate higher cash flow? If you find that you have major holes in your cash flow that won’t support your objectives, consider revenue-based financing options such as merchant cash advance.

Understanding your working capital needs

Well-managed working capital benefits a business by improving liquidity, enhancing operational efficiency, and shortening the working capital cycle. Working capital management encompasses adjusting current assets and liabilities to meet working capital targets, and the processes that facilitate such adjustments.

Your primary goal in managing your business’s working capital is to maintain it within a happy medium between too little and too much. You can do this by controlling your working capital’s components. For instance, you can increase a negative NWC by increasing current assets or decreasing current liabilities, and reduce an overly high NWC by decreasing current assets or increasing current liabilities.

Here are some measures you can try in managing your working capital components:

  • Determine the amount of cash your business needs to meet its daily operational costs without increasing cash holding costs. Additionally, perform an analysis on the  inventory level required to keep production going without increasing the raw material and reordering costs. Both measures will assist in keeping cash flows at a desirable level.
  • Assess your payments collection processes as well. It may be possible to reduce the time lag between preparing and sending an invoice, and between the send date and payment due date, and still keep your customers. Your company could also offer discounts for early-bird payments. Measures like these help reduce cash flow gaps, enable your company to pay its vendors and creditors, and keep working capital positive.
  • If your company does experience a working capital shortfall, choose a suitable business funding source. Traditional banks are not always hospitable to small businesses or start-ups because they may not have had the time or resources to build a stable credit history. Bank loan applications also come with requirements to submit financial statements reflecting a company’s balances, cash flow, and net income. 
  • If your business is facing a shortfall, you cannot expect to produce financial statements that would persuade a bank to fund you. But you may find what you need if you look for alternative funding solutions.
  • An entire industry has grown out of the concept of alternative financing. Providers in this industry cater specially to small businesses that traditional banks overlook. Among the products offered by alternative financing providers are merchant cash advance, small business advance, purchase order funding, equipment financing, invoice factoring, and invoice financing. 
  • These options are for short-term financing that can help you get over a temporary cash-flow gap. Alternative funding services cost a little more than conventional bank loans but are not as stringent in their requirements. These services also offer a shorter approval and fund-release time.