Working Capital Formula: What is It and Why is It Important?
Essentially, working capital represents that which a business has on hand to cover the everyday expenses it incurs. So this would mean the cash on hand as well as any other relevant liquid assets. Working capital can cover such things as payroll, order fulfillment, and marketing/advertising among other day-to-day cost that every business will have. A positive working capital number indicates that your company does have enough money to cover those expenses that need to be covered. Whereas, if your working capital calculation shows a negative number, this could very well mean that it is time to make some immediate changes to better meet financial obligations. In this article, we look closer at the concept of working capital, the main working capital formula, as well as what you might be able to do to improve your working capital.
Most entrepreneurs understand what working capital is. And yet many don't take the time to apply a working capital formula to better understand how much working capital they have at any given time. The working capital formula is part of generating the overall balance sheet. And if a company does, for instance, need to apply for business funding, or if they are trying to get investors on board, being able to show where working capital stands is going to be important. Also known as net working capital, the working capital formula is as follows:
Current assets – Current liabilities
A very straightforward formula, but an incredibly important one to know and utilize for any company.
When using the above formula, keep in mind that assets will include things such as cash, accounts receivable, and inventory that you have. The current liabilities are essentially the accounts payable.
What Working Capital Means As Far As Your Business
While the working capital formula and corresponding calculation provide more of a short term measure of a company's efficiency and sustainability, it is still a crucial number for investors debating whether or not to put their money into a business. With a positive number as far as working capital goes, the company looks more promising and it shows that the business is likely not in danger of falling deep into the red in the immediate future.
If on the other hand, the working capital formula shows that you have negative working capital at your disposal and subsequently cannot meet your day-to-day expenses, this throws up a red flag for potential investors as well as lending institutions to which you may be applying for a loan. Companies that fail and ultimately declare bankruptcy often have negative working capital repeatedly throughout their life cycle. This is why you want to always be aware of where your working capital stands at any given time.
Working Capital and Cash Flow
Let's say for instance, that your business is looking to embark upon a fairly extensive new project. This is likely to some extent going to mean you need to take from working capital to adequately fund the project, along with utilizing other financial means. In this type of situation, you may have to liquidate some assets. This in turn will affect overall cash flow and could potentially hurt business operations. This is why you need to be monitoring all aspects of working capital; in particular, you want to stay on top of outstanding accounts and collect on the money that should be coming in. If after using the working capital formula, you note that you have a negative capital ratio, it is time to implement steps to improve your working capital. Below are a few things you can do to this end.
Improving Working Capital
So what exactly can you do to boost working capital? How can you turn a negative calculation into a positive one? Here are a few tips and strategies for doing just that.
Offer Incentives for On-time Payments
A huge part of why businesses often have low or no working capital is because customers are late with payments. If you offer incentives for early and/or at least on-time payment, you may find that clients are more apt to be forthcoming with those invoices. By the same token, if a customer is habitually delinquent you may need to stop doing business with them all together.
Pay Debts on Time
Letting your debts accrue and paying late will lead to larger interest charges and even penalties. Ensuring that you're paying your creditors on time will help in the long run.
Look for Vendor Discounts
There's nothing that says you can't negotiate with vendors. Even if you've been with a certain supplier for years, you want to make sure you're getting the best price possible. This could mean shopping around and finding discounts and promos. You could always bring that back to a current vendor and see if they're willing to match it.
Most of your debt is going to have interest attached. Sometimes it so happens that the interest on a loan or credit card could be subject to modification. It certainly doesn't hurt to call/email the creditor in question and revisit the terms as regards the interest being paid. This could make your monthly payment lower and thus help boost the working capital you have available.
Moving inventory is critical to bringing in more money. If items are just sitting stagnant this is ultimately costing you. It could therefore be time to more effectively manage your inventory and cut products that simply are not selling.
Automate Where Possible
The more you automate, the better off you will be. From how you make payments to how you track expenses, automation enables you to be far more efficient than you otherwise probably would be.
Resolve Any Disputes ASAP
Disputes can get ugly in a hurry—some could potentially even turn into court cases, and then this of course will add up quickly. Be it with a customer or vendor, make sure you approach every dispute strategically and tactfully and get it resolved as soon as possible.