A Guide To Understanding Working Capital

Cash is the lifeblood of any business that’s hoping to thrive and scale. If there are cash flow problems, it becomes difficult for the business to fund its operations, which can quickly lead to its downfall. This is why access to working capital and good working capital management are so important. 

What is working capital?

Working capital represents the capital used in day-to-day operations. It is also known as Net Working Capital (NWC). A simple way to think if it is the resources available to cover day-to-day needs. It’s what keeps the wheels of your business turning.

Working capital is calculated as the difference between a company's current assets and its current liabilities (i.e., what a company owns in the short term and what it owes). Current assets include cash, inventory, accounts receivable, and other short-term assets, while current liabilities include accounts payable, short-term debts, and other obligations that the company needs to settle within a year.

For businesses, your working capital is an important metric that gives you an idea of your operational efficiency, short-term financial health and how liquid your business is. Think of it as a litmus test for a company's agility and sustainability. Without sufficient working capital, a company might find itself grappling with settling bills with suppliers, struggling to make payroll, or unable to seize promising opportunities for growth. 

A healthy working capital position not only ensures the lights stay on but also positions a company to weather uncertainties, meet its short-term obligations, and capitalize on strategic initiatives. 

Types of working capital

There are two primary types of working capital: gross working capital and net working capital. Gross working capital refers to the total of a company's current assets, while net working capital refers to the difference between current assets and current liabilities. Let’s break these down in more detail:

1. Gross working capital

This represents a company's total current assets, including cash, marketable securities, inventory, accounts receivable, and prepaid expenses. These assets are very liquid and, hence, can be quickly converted into cash. The more gross working capital a company has, the better it can handle its short-term bills.

2. Net working capital

This is more popular and often what we’re referring to when we talk of working capital. Net working capital is a more precise indicator of a company's liquidity. You get your net working capital by subtracting your current liabilities from your current assets. Current liabilities are simply the short-term obligations your business has to pay, usually within a year.

Net working capital shows how much money you have left after you’ve settled your bills/short-term debts.

The importance of working capital in business

Now that you understand what working capital is let’s move into why it’s such an important metric in business:

1. Smooth operations

Adequate working capital ensures the possibility of smooth day-to-day operations. It allows a business to meet its short-term obligations, such as paying suppliers and covering regular expenses like utilities and rent. It also acts as a buffer during unforeseen circumstances, such as economic downturns or unexpected expenses. It provides a safety net, reducing the risk of insolvency.

2. Inventory management

Working capital is essential for managing inventory levels, enabling businesses to maintain optimal stock levels, and preventing outages.

3. Cushion for slow payments

Sufficient working capital provides a financial cushion for businesses, especially when customers delay payments. It helps to bridge the gap between accounts payable and accounts receivable.

4. Seizing opportunities

Having working capital offers the flexibility to adapt to changes, whether it's exploring new markets or adjusting production levels. Adequate working capital allows businesses to take advantage of unexpected opportunities, such as bulk purchasing at a discount or investing in a sudden market trend.

Even if a company has cash surpluses, it needs to ensure that this cash is utilized optimally. Working capital management helps in deploying excess cash into investments or activities that generate returns. This could include investments in research and development, expansion projects, or other avenues that enhance owner and stakeholder value.

5. Seasonal demands

Many businesses experience seasonal fluctuations in sales. Sufficient working capital helps companies navigate through lean periods and capitalize on peak seasons without disrupting their operations.

6. Lender & stakeholder confidence

Maintaining healthy working capital ratios enhances a business's creditworthiness. Lenders and creditors often view a strong working capital position as a positive indicator of a company's ability to meet its financial obligations. Similarly, investors and stakeholders are more likely to have confidence in a business with strong working capital management. It demonstrates financial stability and responsible financial practices.

Components of working capital

To better understand working capital, let’s look closely at its two main components: current assets and current liabilities.

1. Current assets

Current assets are short-term liquid assets that can be used up or converted to cash within one year or one operating cycle. They include:

• Cash and cash equivalents: This includes physical currency on hand, balances in bank accounts, and short-term investments that can be easily converted into cash. Cash equivalents are highly liquid and have a very short maturity period.

• Accounts receivable: These are amounts owed to the company by customers who have purchased goods or services on credit. It represents revenue that the company has earned but hasn't received in cash yet.

• Inventory: Inventory consists of the goods and materials that the company holds for production, resale, or as part of its operations. It includes raw materials, work-in-progress, and finished products.

2. Current liabilities

Current liabilities are the business’s obligations that must be settled within a year. They include:

• Accounts payable: These are amounts the company owes to suppliers and vendors for goods and services that have been purchased on credit. Accounts payable represent the company's short-term obligations to its suppliers.

• Short-term debt: Short-term debt includes loans and other financial obligations that the company must repay within one year. It represents the portion of long-term debt that is due in the near future.

• Accrued liabilities: Accrued liabilities are unpaid expenses that the company has incurred but has not yet paid. These can include wages and salaries, taxes, utilities, and other outstanding bills.

How to calculate working capital

Understanding the working capital formula is crucial for assessing a company's financial health. Calculating working capital is a pretty straightforward process, and the formula is simple:

Working Capital = Current Assets - Current Liabilities

It can also be expressed as a ratio. In this case, it’ll look like this:

Working Capital Ratio = Current Assets / Current Liabilities

Your business can either have a positive or negative working capital. When your business has positive working capital, it simply means it has enough current assets to cover its day-to-day expenses while having reserves for unforeseen circumstances.

On the other hand, a negative working capital implies that your business might struggle to cover essential expenses such as inventory, payroll, and payments to suppliers. Let’s take an example. 

Imagine that a company has $500,000 in current assets and $250,000 in current liabilities. In this case, the working capital is $250,000. 

Working Capital: $500,000 - $250,000 =  $250,000 

This means the company has $250,000 available to meet short-term obligations and sustain its day-to-day operations. Now consider another scenario where a company has $100,000 in current assets and $120,000 in current liabilities, the working capital, when calculated, gives a negative balance.

Working Capital: $100,000 - $120,000 =  -$20,000 

A negative working capital of -$20,000 indicates that the company does not have enough funds to cover its short-term liabilities. 

Having a negative net working capital doesn't necessarily spell doom for a business. Sometimes, it's a temporary situation tied to specific business cycles or seasonal changes. However, consistently operating with negative net working capital can strain your company’s finances, limit growth opportunities, and potentially lead to insolvency if not addressed promptly.

Interpreting working capital ratios

As we already mentioned, a company’s working capital can also be calculated and expressed as a ratio. Like the working capital formula, the working capital ratio is a valuable metric for evaluating a company's financial health by assessing the relationship between its current assets and current liabilities. Calculated as the ratio of current assets to current liabilities, it is expressed as:

Working Capital Ratio= Current Liabilities / Current Assets

​This ratio offers a quantitative assessment of a company's ability to meet short-term obligations. Essentially, it reveals the amount of current assets available to cover each dollar of current liabilities.

• Ratio Greater Than 1: A working capital ratio greater than 1 implies that a company has more current assets than current liabilities. This indicates a positive financial position, suggesting the company is well-prepared to handle immediate financial obligations and has some cushion and room for investment in growth opportunities.

• Ratio Less Than 1: Conversely, a ratio less than 1 suggests that a company may face challenges meeting short-term obligations. This could indicate potential liquidity issues, emphasizing the need for careful working capital management to avoid financial distress.

It's essential to strike a balance, though. While it’s true that a high working capital ratio suggests that a company can cover its short-term debts, having an excessively high ratio might signal inefficiencies in resource management. Finding the right balance is key to optimizing working capital and maintaining financial stability.

Strategies for efficient working capital management

When it comes to managing net working capital, businesses need to adopt effective strategies that can help them optimize their financial resources. Some of these include:

1. Inventory management

Maintaining optimal inventory levels is key to avoiding unnecessary carrying costs while ensuring there is enough stock to meet customer demand.  This involves closely monitoring stock levels, analyzing sales trends, and forecasting future demand. Efficient inventory management prevents overstocking or understocking. This ensures capital is utilized efficiently without risking lost sales.

2. Accounts receivable

Your accounts receivable refers to your customers who owe you money. Streamlining the accounts receivable process can help minimize the time it takes to collect payments from customers and improve cash flow. An effective approach to achieve this includes establishing clear payment terms, promptly issuing invoices, and actively following up on overdue payments. By implementing automated invoicing systems and offering convenient payment options, businesses can expedite the collection process and reduce the risk of bad debts.

3. Accounts payable

Negotiating favorable payment terms with suppliers preserves cash by providing additional time to settle liabilities. Building strong relationships with suppliers and negotiating favorable credit terms are key aspects of managing accounts payable.  By extending payment terms without negatively impacting supplier relationships, businesses can optimize their cash flow and maintain positive working capital.

4. Optimizing cash conversion cycle

The cash conversion cycle measures the time it takes for a business to convert its investments in inventory and other resources into cash through sales. By streamlining the production and sales process, businesses can reduce the time it takes to convert raw materials into cash. A business can achieve this by identifying and eliminating bottlenecks in the production and sales process, thereby accelerating cash inflow and improving its working capital position.

5. Cash flow forecasting and planning

Cash flow management is another crucial factor in managing working capital. A clear understanding of cash flow needs empowers businesses to proactively manage working capital, preventing cash shortages.

Accurate forecasting and planning allow businesses to anticipate future cash flow needs and ensure adequate working capital is available.

This process entails analyzing historical data, market trends, and business projections to estimate future cash inflows and outflows. Expense control and regular budgeting are also practices most companies employ to maintain healthy and positive cash flow. 

Understanding working capital financing

Even with effective working capital management, businesses sometimes require additional funding to sustain or expand their operations. Working capital financing options offer a solution, providing access to capital for day-to-day activities and growth initiatives. 

These options encompass traditional bank loans, lines of credit, and invoice financing, and merchant cash advance, among others. Each financing option is designed to provide flexibility and support, whether a business is navigating challenging times or pursuing expansion. Let's explore some common types of working capital financing:

1. Working capital loans or traditional bank loans

These loans are typically offered by traditional banks and often require collateral or a personal guarantee from the business owner. They typically come with fixed interest rates and set repayment terms. While they can be a reliable source of funding, the application process can be more lengthy and strict, making it accessible mostly to businesses with a solid credit history and assets to use as collateral.

2. Working capital lines of credit

Lines of credit provide businesses with a predetermined credit limit that they can draw from as needed. One of the advantages is that interest is only charged on the amount borrowed. This flexibility makes it a popular choice for covering short-term working capital needs, such as inventory or payroll.

3. Invoice financing

This financing option allows businesses to borrow against their outstanding invoices. It provides immediate cash flow by advancing a percentage of the invoice value. Invoice financing can help businesses bridge cash flow gaps caused by delayed payments from customers. It's particularly useful for service-based businesses with outstanding accounts receivable.

4. Merchant cash advances

Merchant cash advances (MCAs) are an alternative to traditional lending. With an MCA, businesses receive a lump sum up front in exchange for a percentage of their future credit card sales. This option is especially popular among retail and hospitality businesses, and is expanding as more industries accept electronic forms of payment. 

Each of these financing methods serves specific working capital needs and comes with its advantages and drawbacks. The right choice for your business will usually depend on factors like its financial situation, credit history, and the urgency of the capital requirement. 

Pros and cons of working capital financing

Like any financial decision, working capital financing comes with its own set of pros and cons. Let's explore them in more detail:

Pros of working capital financing

• Immediate access to capital: Working capital financing provides businesses with quick access to the funds they need, allowing them to address urgent expenses or capitalize on time-sensitive growth opportunities.

• Supports growth initiatives: Businesses can use working capital financing to invest in growth opportunities, such as expanding operations, launching new products, or entering new markets.

• Bridges cash flow gaps: During slow periods or seasonal fluctuations, working capital financing can help bridge cash flow gaps, ensuring that businesses can continue their operations without disruptions.

• Inventory management: Adequate working capital financing enables businesses to maintain optimal inventory levels. This is crucial for meeting customer demand, avoiding stockouts, and optimizing supply chain operations.

Cons of working capital financing

• Impact on profitability: Debt repayment obligations associated with working capital financing can impact a business's profitability. Allocating a portion of revenue to repay loans reduces the funds available for other operational or growth initiatives.

• Cost of borrowing: Interest rates and fees associated with working capital loans contribute to the overall cost of borrowing. High borrowing costs can erode profits and diminish the financial benefits of obtaining financing.

• Collateral or personal guarantee: Some types of working capital financing may require businesses to provide collateral or a personal guarantee. This adds an additional layer of risk, especially if the business faces challenges in meeting repayment obligations.

• Dependency on debt financing: Relying too heavily on working capital loans can lead to a dependency on debt financing. Over-reliance on debt may limit a business's financial flexibility in the long term and increase vulnerability to economic downturns.

You want to carefully conduct a thorough assessment of your business’s financial needs, cash flow patterns, and risk tolerance before choosing a working capital financing option.

It's essential to weigh the benefits against the costs and consider the long-term implications on your business's financial health and sustainability. If all these seem like Greek to you, then you may want to consider seeking external help, like a CPA, to help you make the best decision for your business.

Bottom line

For most businesses, the popular conversations are centered around profitability. While profitability is essential for a business's long-term success and growth, it's important to recognize that your business can technically survive without consistent profitability. This is particularly true for startups, which may initially operate at a loss as they invest in growth and market share.

Conversely, the absence of liquidity poses an immediate threat to your business. Liquidity ensures that you can meet your short-term obligations, pay bills, and cover day-to-day operational expenses. So, while profitability is a long-term goal, and indeed, an important one, liquidity in the form of working capital is a critical lifeline for immediate survival and operational stability.

For small- and medium-sized businesses looking for working capital, Pipe may be the perfect solution. Unlike lenders, Pipe can help you access fast, frictionless working capital based on your live revenue data and the health of your business, not on collateral and credit scores.

Find out how Pipe can connect your business with working capital that works for you.