What is working capital and why is it important for business?

What is working capital and why is it important for business?

“What is working capital?” is a common question from small business owners. Here, we go over the fundamentals to help you comprehend working capital and its significance.

For many different business owners, working capital might imply many different things. So to make it easier for you to comprehend what it is and how to use it to your advantage, we’ve put together a simple summary:

Working Capital: What Is It?

Working capital, frequently abbreviated as (WC), is a concept that most business owners are familiar with. If you’re wondering, “What is working capital?” it’s the difference between the company’s current assets and its current liabilities, which are short-term obligations, as seen on a balance sheet. In this sense, anything that a business owner can convert into cash within the upcoming year is considered a current asset. The fees and expenses a business incurs during such time are known as liabilities.

Accounts receivable, inventories, pre-paid expenses, cash and cash equivalents, and marketable securities are a few examples of current assets. In contrast, current liabilities consist of client deposits, accounts payable, wages payable, income taxes payable, and interest payable.

Working capital is an indicator of the short-term financial health of an organisation. It shows if a business has enough short-term assets to pay for ongoing expenses and short-term debt. However, WC and cash flow aren’t the same, despite similarities. Both of these indicators of financial wellness are crucial. Working capital is a picture of the present, whereas cash flow assesses the capacity to produce cash over a
given time frame. The majority of businesses with strong cash flow also have strong working capital. However, depending on factors like investments, paying off previous debt, and paying dividends to shareholders, there may be some variance. You can determine your working capital using the following method if you are aware of your current assets and liabilities:

WC= current assets – current liabilities

Net working capital is the term occasionally used to describe the difference between current assets and current liabilities.

Identifying Your Needs for Working Capital

A business will typically aim for a positive current assets to current liabilities ratio (WC ratio). Theoretically, a company with a working capital ratio of 1.0 should be able to cover all of its short-term expenses, but the majority of firms (as well as analysts, banks, auditors, etc.) like to see that number a little higher. Excess WC can be put back into the company to support growth and act as a sort of “cash cushion” for unforeseen needs. A ratio below 1.0, however, suggests that current assets are insufficient to pay down short-term debt and may signal that a company needs extra funding.

A working capital ratio that is ‘healthy’ is typically seen as being between 1.2 and 2.0. This demonstrates solid long-term financial health and adequate short-term liquidity. But there can be a problem if the ratio is too high. A ratio greater than 2.0 may indicate that a company isn’t aggressively spending its extra cash and assets into growing the business, which isn’t necessarily a “bad” situation. This could be a sign of bad money management and lost business possibilities.

Tips for Working Capital Management

A variety of variables will affect how much positive working capital a business requires to operate successfully. These include business kind, operational cycle, and present and long-term growth objectives. Due to their rapid access to money, large companies can temporarily get away with having a negative working capital ratio, while small to medium-sized companies must actively maintain a healthy level of WC.

The amount of working capital needed for a given business model will vary. For instance, physical inventory is held by manufacturers, distributors, and retailers. Manufacturers must buy raw materials, make their goods, and then sell them. This frequently necessitates much more working capital. Conversely, businesses that offer intangible services, such as consultants or web designers, typically have substantially smaller working capital requirements. Additionally, mature companies that have already completed their growth phase and are no longer seeking quick expansion won’t require a lot of working capital.

As they get ready for their busy season, many seasonal firms will have considerably higher working capital requirements during specific times of the year. How much working capital a business needs might also depend on how long its operational cycle is. Businesses will
require greater working capital during the intermediate periods if a product takes longer to produce and sell. The same is true for businesses with slow-paying clients.

The first step to managing healthy finances is to have a thorough understanding of all the variables that can impact your WC needs. If your business is seasonal, planning when and how much cash you could need in a pinch might ease short-term liquidity problems. If you have clients who are sluggish to pay, you might need to adjust spending to make up for a shortfall in cash while you wait for the payments.

A cash flow statement is one tool you may use to manage working capital.

Even if you want to grow quickly, you will need more capital on top of any funds set aside for expansions (such as a new shop, equipment, etc.).

Solutions for Small Business Financing

It has been said that the majority of Small to medium Enterprises (SMEs) seeking WC help and almost 60% of SMEs are wanting to borrow. The main cause of this, according to the research, was overdue payments (especially from big government and business sector
organisations). Additionally, it was shown that the typical debtor time is now above 50 days and growing.

At least half of all Australian SMEs have negative cash flow at some point during the year, according to Xero’s Small Business Insights research, which examines Australian business statistics. The annual variation in this value is moderate. In contrast, more businesses
experience negative cash flow in the months leading up to Christmas and into January.  Unsecured business loans are one way to get beyond this obstacle.

The significance of a good WC ratio in any organisation is reiterated by all of these findings. They also demonstrate the fact that many businesses require financial assistance. This isn’t necessarily a sign that they are “bad” businesses. In actuality, the opposite is frequently true.

Regular short-term working capital loans are used by many businesses with cyclical sales cycles to cover the difference between client payments or to assist during lean periods. These short-term loans are taken out by businesses who are neither in debt nor experiencing cash flow issues, but instead want to increase profits. Additionally, they take out loans before busy seasons (or when they are awaiting payments).

They then expand sales and, as a result, profits using the extra corporate capital. When all of their sales are completed, they subsequently pay back the loan.

It could be challenging at initially to comprehend your particular financial needs. But once you do, it really contributes to the seamless operation of your business.