What is Working Capital, and Why Does My Business Need It?

10 May 2022

Running a successful business often means a delicate balancing act in your cash flow, managing money moving in and money moving out. While cash flow is a useful measure of your business’s financial health at a point in time, it doesn’t take into account other important categories like liabilities and assets.

That’s why it’s vital you also have a handle on your business’s working capital. But what is working capital, and why is it so important? Here’s everything you need to know about it, including the working capital formula and how you can improve your business’s working capital.

What is Working Capital?

In a nutshell, it’s the difference between a business’s current assets and liabilities, and that amount is your operating liquidity.

Assets:

  • Money in business bank account(s)
  • Accounts receivable (money owed to you)
  • Inventory (materials and products)

Liabilities:

  • Accounts payable (money you owe, to suppliers etc)
  • Business debts

Working capital formula: Current assets – Current liabilities

Why is Working Capital Important to my Business?

Ultimately, the amount of working capital in a business shows how well (or not) it's performing. Whether it’s to help shape business strategy or to show investors the business is worth investing in, working capital is an important part of understanding your business’s financial health.

If your working capital is somewhat low, you might struggle with unexpected expenses and your ability to grow the business. You might think that the higher your working capital, the better, but too high could be an indication that you have too much money tied up in inventory or cash that you’re not reinvesting properly.

How to Calculate Working Capital Ratio

There’s more to understanding your business’s working capital than just the value of it, and that’s where working capital ratio comes in.  Different businesses might easily have the same amount of working capital, but they could have very different positions in terms of assets and liabilities.

Working capital ratio= Current assets/Current liabilities

To calculate working capital ratio, divide your current assets by your current liabilities. This gives you your working capital ratio, and will generally be a figure between 0.5 and 3.

Let’s compare two hypothetical businesses:

Business A has assets totalling £500k and liabilities totalling £200k.

Working capital: £500,000 - £200,000 = £300,000

Business B has assets totalling £1.25m and liabilities totalling £1m.

Working capital: £1,300,000 - £1,000,000 = £300,000

So we can see that the value of working capital that both businesses have is the same, but does the working capital ratio tell us more?

Business A

Working capital ratio: 500,000/200,000 = 2.5

Business B

Working capital ratio: 1,300,000/1,000,000 = 1.3

In both of the above examples the value of working capital is the same, but the working capital ratios reveal different financial positions.

The ideal working capital ratio is between 1 and 2. Less than 1 suggests there could be issues with liquidity in the future, and above 2 indicates a potential problem with cash not being reinvested back into the business.

 

Ways to Improve Your Working Capital

If you think your business’s working capital could be improved in order to access more opportunities and drive growth, there are ways to do it. 

Reduce your expenses

Look at where your business can reduce costs. When you do this, it’s important to measure the savings you might make with the impact on your employees or customers.

Work on bad debt

Bad debt, or outstanding invoices that you haven’t been able to collect, can really impact working capital. Work on resolving any queries that has led to your customers withholding payment, and sharpen your credit control/accounts receivable processes to try to avoid more bad debt from accumulating.

Tighten up inventory management

 Holding on to inventory, be it stock or materials, is a drain on your liquidity. You don’t want to hold too little that you can’t fulfil customer demand, but work on optimising inventory to get the right balance.

Look for funding

There are a number of potential funding sources available to improve working capital, and two of the most common are working capital loans and business credit cards. Working capital loans are, as the name suggests, specifically for this purpose. Business credit cards, on the other hand, offer much more flexibility.

A small business credit card from Capital On Tap helps boost cash flow, having a positive impact on working capital, as well as other benefits like flexibility, perks/rewards, easier approval, and more.  

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