First off, it’s important to understand what working capital is and consequently what it consists of. Essentially, working capital is what your business has on hand every day to take care of its functions. So for instance, this might include cash, accounts receivable, securities that are marketable, inventory and the like. Such things are easily convertible to cash and thus can be utilized to help your business operate day to day.
You also though, have to take into account your liabilities when considering working capital. Liabilities are the immediate or short term obligations that you have to pay (usually within less than a year). Taxes, your insurances, any lines of credit, are all among your company’s liabilities. The goal of course for any business owner is for your assets to outweigh the liabilities, thus leaving you with positive working capital.
The Importance of Having Working Capital
You need to have the healthy working capital to sustain your business. By calculating your working capital, you are better able to determine how capable you are of functioning going forward. Are you able to meet obligations? Can you also invest in things that will help bring in income? Our working capital calculation will give you a good idea of your business’s solvency.
Calculating Working Capital
As a small business owner, you have to know how to come up with your working capital calculation. It’s not that complicated. It will look like this:
Net Working Capital = (Current Assets) – (Current Liabilities)
Pretty simple. The key is to gather all of the pertinent details regarding liabilities and assets so that you’re leaving nothing out of the equation. The more thorough you are, the better!
As an example, let’s say between debt and accounts payable your liabilities stand at 15k. On the other side of that coin, you have the following assets on hand: cash 20k, accounts receivable 5k, inventory 10k. Your working capital calculation would thus come out to 20k in positive net working capital.
Positive vs. Negative
Obviously, upon calculating working capital, you want to come out on the positive side. When you have positive working capital, this indicates that your business is doing well financially, you can take care of your responsibilities as far as payments, loans, etc., and you may even be investing in other activities to generate income.
On the other hand, should you arrive at a negative number, this could mean you have to start making adjustments. Perhaps you need to better utilize current assets, or you might lack assets all together to keep up with your liabilities. Not to mention, it could suggest that sales have slumped off—and this isn’t good news.
With negative working capital, you may be feeling the pressure which in turn has you borrowing more than you can afford. The result: late payments or even defaulting on payments. Your credit score may be taking a hit. A negative number though doesn’t have to sell your business’s demise.
What Happens if You Do Have Negative Working Capital?
There are ways to improve your working capital outlook. So even if you do come up with a negative number, don’t despair. Below are a few tips and some advice regarding ways you can help your business move from the negative to the positive side of the equation.
1. Move Inventory More Quickly
Yes, your inventory is an asset; however, unlike other forms of inventory, i.e. cash, it isn’t quite as liquid and thus your money and valuable resources are tied up in said inventory. If you happen to be holding onto this inventory for a long period, this is gradually becoming wasteful. That money could be used for other endeavors—things that might just get you back on the plus side.
You need to start moving that inventory faster. How exactly do you go about accomplishing this? For one, refrain from over-ordering. Also, go back and rethink certain items. You may have thought it a winner, but it simply isn’t moving. See if you can return unused inventory. Offer products at a discount, within reason. Just get it off the shelves!
2. Revisit Long-Term Assets
Like unsold inventory, these assets are tying up cash that could be otherwise useful to you. Consider things such as equipment, office space, real estate. Are you using them? Is there a way you could sell them and thus use the funds for needed cash flow? Look long and hard at what the company has versus what it truly does not need at this particular juncture. You may also consider renting out long term assets. Perhaps a piece of equipment is sitting idle—could it be rented? Extra office space? Caveat: as you rethink your long term assets don’t be in a rush to dump all of them—they could be useful for collateral.
3. Refinance Debt
If your credit history is decent, then refinancing may be a smart option for you to explore to get back on that plus side. You might be able to take short term loans and turn them into long term, this then means you will have a longer time to repay and your monthly responsibility will decrease. This frees up cash each month that could be used for working capital.
4. Accounts Receivable
We all know that sometimes getting money from customers can be tough. Invoices linger and before you know it, you could be out thousands. Offer incentives for early payment, enforce penalties for late payments; just find a way to reduce the number of accounts receivable you currently have out there.
Your Business: Your Working Capital
This is your company, you need to understand the big financial picture and you can’t do that without understanding how to calculate working capital. As you can see it’s a relatively simple formula, you just have to commit yourself to do a thorough job of gathering all of the information needed.