Working capital is also known as “net working capital” because to be in the black, your working capital needs to be positive. It’s a measurement comparing a company’s assets, accounts receivable, inventories, and liabilities. Basically, if your company comprehends working capital and plays the formula right, you will be able to reinvest in your business and continue growing.
Businesses that do not understand working capital or how to manage it, on the other hand, will result in poor levels of investment back into the business (whether it is in marketing, equipment, or other resources), and even poor payouts to staff or layoffs.
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What is working capital?
Basically, working capital measures the financial health of a business in the short term. Are you able to pay your bills? Good. You probably have positive net working capital.
The working capital equation is simple: current assets - current liabilities = net working capital
You can easily find these measurements on your balance sheet.
Overall, in order to remain viable, your company should have a positive working capital ratio. Ideally, your business should be able to pay off its debt while still having some money left over to reinvest in the business.
On the other hand, a negative working capital indicates that your business owes more than it is flush with and is a good sign that you need to increase your cash flow right away.
There are 4 main components of working capital
- Cash management - maintaining a good cash balance (therefore, managing cash flow) is crucial for achieving a positive working capital.
- Receivables - managing your accounts receivable and collecting the funds that are owed to your business is an easy way to increase your working capital quickly.
- Inventory management - efficiently managing your inventory (including raw and finished goods) will allow you to optimize your operations. Don’t tie too much funds into creating or storing inventory with no guaranteed buyers.
- Accounts payable management - basically, arranging and paying your expenses in a timely fashion. You don’t want to owe too much at once unless you’ll be able to deliver.
What to do if you do not know your current assets and current liabilities?
If you do not have a balance sheet, don’t worry. You can calculate these numbers on your own by measuring the four main components of working capital, and subtracting all your current liabilities (debt commitments).