Working capital is the total amount of money a business has for running day to day business such as payroll, inventory, and money for unplanned expenses.
The amount of working capital is equal to your current assets minus current liabilities. Current assets are so-called liquid assets that consist of cash and quick assets, which are assets that can easily – within a year – be converted into cash. Besides cash, you will find the following items under the current assets: cash, accounts receivable, other receivables (income tax refunds, cash advances to employees, etc.), inventory of finished products or raw materials, prepaid expenses and advance payments on future purchases.
Current Liabilities are short term liabilities that are due within one year: accounts payable, short term loans, bills payable, income tax payable, etc.
Liquidity Indicators and Why They Matter
The notion of liquidity is closely related to working capital. It refers to the ability of a business to pay its bills as they come due. Every business needs to closely monitor whether there are enough current assets to cover current liabilities to ensure that daily business operations are running smoothly. For this reason, several indicators are developed to assess whether a business has an adequate liquidity profile – whether the ratio of current assets to current liabilities is adequate.
- The current ratio is equal toal current assets divided by all current liabilities. It measures the capability of a business to meet its short-term obligations. A rate of more than 1 suggests financial well-being, and the rate below 1 indicates negative working capital, which means liquidity problems. On the other hand, a ratio that is consistently very high is not necessarily good either. It may indicate that your business is not investing its cash or that it built up too much inventory.
- The quick ratio: Current assets minus inventory divided by current liabilities. It measures the ability of a business to pay its short-term liabilities with assets that are quickly convertible into cash. Inventory is not included here as it is usually less liquid – you need more time to convert it into cash.
- The cash ratio is cash divided by current liabilities, and it measures the business’s ability to meet its short term obligations using cash only.
Liquidity indicators are essential as they measure whether your business has enough resources to meet its short-term obligations like accounts payable and operating expenses. Business owners and banks or other lenders want to look at these as they indicate short term financial health – whether a business is viable in the short term.
Working Capital Management Best Practices
When you are assessing your working capital needs, it is essential to consider your cash, inventory, account receivables, and account payables. If you want to keep enough working capital to maintain an uninterrupted operating cycle, you need to assess your inventory and account receivables/payables turnover. It is also important to note that the typical level of working capital ratios (current, quick, or cash ratio) will differ between industries and even within industries. Service industries will generally have lower working capital compared to manufacturing – but retail, for example, will have higher inventory.
By managing your working capital, you can free up more cash. It is therefore essential for your business to reconsider the operating cycle in order to optimize major elements of working capital – inventories, accounts receivables, and account payables. Working capital management will include procedures aimed at:
- collecting receivables faster
- optimizing the level of your inventory
- paying later
Your business can achieve a reduction in account receivables if you change terms of payment, invoicing procedures, credit control, and chasing payments.
You want to keep enough inventory to enable smooth business operations, but you don’t want to tie up too much cash into excess inventories. Reconsider your supply chain management in order to assess whether additional funds could be freed up here. You can also find various working capital funding solutions on our site.
You may also want to manage accounts payable – the money you owe to your suppliers- by optimizing terms of payment, payment procedures, and discounts.
Working capital is an essential aspect of your business as it enables you to run day to day business operations. As such, its level should be closely monitored on a regular basis. By actively managing your working capital, you can free up cash that can be invested elsewhere in your business. Several indicators can help you with assessing short term financial health of your business – current ratio, quick ratio, and cash ratio. Remember that you want to see a current ratio above 1, but not extremely high. If your ratio is lower than 1, it means that your business has a negative working capital and needs additional funds. You can finance the shortfall through short term or working capital loans, invoice financing and factoring, business line of credit or merchant cash advance.