If you’ve heard the term “working capital” thrown around lately, but you’re not entirely sure what it means, this post is for you.
Working capital is necessary for businesses every day, since they need a certain amount of cash in order to make routine payments, purchase basic materials, and cover any unexpected costs.
This is linked to your cost of living. Consider the fact that you need to collect any money that you’re owed, and have enough cash each day to cover your day-to-day expenses, and any bills you need to pay.
Working capital is a good way to measure the liquidity, efficiency, and overall financial health of an individual or company. When a company or individual don’t have enough working capital to cover their obligations, this can lead to financial insolvency, legal troubles, asset liquidation, and even bankruptcy. For this reason, understanding working capital is hugely important.
Working capital management is about focusing on maintaining a sufficient balance between your liabilities and assets.
Your current assets are those that you can turn into cash within one year. These include prepaid expenses, accounts receivables, cash, and cash equivalents.
Your current liabilities are those liabilities that you’re expecting to pay within either one business cycle or one year. These include accrued income taxes, accrued liabilities, accounts payables, capital leases, dividends payable, and long term debt that’s due within that year.
A financially healthy individual or business will be able to pay their current liabilities with their current assets. To work out if this is possible, take your current assets and divide them by your current liabilities. If you get a number above 1, your current assets there fore exceed your current liabilities which is a good sign. The higher that number, the better you’re doing financially.
Another way to work this out is through the quick ratio. This looks at your short-term liquidity compared to your current liabilities. When compared to the current ratio, the difference is the numerator. This is when your asset side includes receivables, marketable securities, and cash. Inventory is left out of this equation, as this can be more difficult to quickly turn into cash over the short-term.
While the formula for calculating your is relatively straightforward, it’s an excellent way to understand your financial health. If you’re starting or currently own a small business, this can be especially important as it allows your investors to see how your company can handle any short-term obligations.
If you get a number below 1, it’s a good indication that you’ll need to quickly make some changes in order to improve your working capital. This could be earning an influx of cash or cutting expenses to change this calculation and therefore your score and amount of working capital.