Starting a business takes time, effort, and certain money funds that aspiring entrepreneurs must include in their financial prediction regarding initial investment costs. We will outline what working capital is; its definition is pretty simple, so we will dive a little more and show what this parameter can tell about a company and its financial health in general.
- Working capital is the balance between a company’s current assets and current liabilities; by calculating its ratio, we can uncover the company’s financial health.
- If the working capital is too low or too high in both cases, that can indicate that something in business operations isn’t done properly.
- The business will need to make a list of assets and liabilities in order to make a working capital calculation.
- If the company can’t meet its short-term liabilities, it means that the business isn’t financially sustainable in the long run. So the manager/owner will need to change the direction in which the company is now going, or business failure is unavoidable.
What is Working Capital
Working capital, often referred to as net working capital, is the difference between a company’s current assets and liabilities. This parameter is often used to measure the short-term health of a company.
A company’s working funds also depend on the industry in question. If a company sells a product that requires a long time to manufacture, like certain crops, accumulating this type of money can take time.
In practice, the length of the time to collect funds for the ongoing operating costs depends on the time of manufacture. Until the money from the products rolls in, the business needs to find other ways to procure working capital.
If a business sells a product with a low manufacturing time, like fast fashion, the company can accumulate the necessary operational funds in a small amount of time. However, every industry has its particularity regarding the financial aspects of doing business.
For example, if the investor chooses to open a franchise, the financial prediction must incorporate working capital for the first three months of operation.
From idea to the time when the business will start making money usually pass a few months, so aspiring entrepreneurs must count that in the beginning, they will pay all operational and pre-operational costs from their pockets.
What the Working Capital of a Company Can Tell
If the working capital is negative or too low
If a company’s working capital is too low, it doesn’t have enough assets to pay its current liabilities. The company has more short-term liabilities than short-term assets. This means the company has low liquidity and may have problems when it comes to paying not only debt obligations but also expenses like workers’ wages.
If the working capital is too high
Having a working capital that’s too high can also indicate weaknesses in a business. It could mean the company has too much inventory or isn’t investing the available cash. It could also mean the company isn’t taking advantage of low or no-interest loans.
Assets and Liabilities That Must Be Included in Working Capital Calculation
An asset is a resource with economic/financial value that a corporation owns or controls. So it is very important to make a list of assets and to know their financial value.
Some assets considered when calculating the net working capital are as follows:
- Cash and cash equivalent: This includes all the cash the company has in hand, the company’s foreign currency, and the low-risk investments the company has made.
- Inventory: Inventory includes all the unsold products a company has in stock. In addition, inventory includes raw materials used to create the product, partially assembled products, and finished products that are yet to be sold.
- Accounts receivable: Accounts receivable refers to cash to be received by clients for inventory items provided on a credit basis.
- Notes receiveable: Claims to cash due to other agreements are often agreed upon through a physically signed agreement.
- Pre-paid expenses: Pre-paid expenses are difficult to liquidate, but they are nonetheless considered assets and can carry short-term value.
A liability is a financial burden carried by a company that requires the company’s future economic benefits to be sacrificed to other entities. It can be described as already spent money, so it is very important to know what bills will come to our company address at the end of the month.
- The amount payable: All unpaid invoices like rent, property tax, other taxes, or any other money owed to a third party by the company.
- Wages payable: Wages payable refer to all the wages and salary that needs to be paid to staff members. Wages are short-term liabilities since most companies pay wages monthly or even more often.
- Current payment for a long-term debt: Since working funds calculation is made for the short term, often 12 months, only the current payments that need to be paid for long-term debt are considered. If the time frame of interest is 12 months, but the debt needs to be repaid over ten years, only the payments for the 12 months in question are considered.
- Dividend payable: This refers to all authorized payments for shareholders. While future dividend payments can be declined, the already authorized ones are a company’s obligation.
- Unearned revenue: All payment received in advance to a job being completed is unearned revenue. If, for example, the company fails to provide agreed-upon services, they might be forced to return the money they charged.
Limitations of Working Capital
While insight into working capital can give a pretty good understanding of a company’s short-term health, it can be deceptive for several reasons.
Here are some of those reasons:
- A company’s working funds are frequently changing, so it’s hard to keep track of and make projections of it a few months in advance.
- Assets considered when calculating the available working funds of a company can be devalued. For example, accounts receivable can be reduced if clients file for bankruptcy and cannot pay their dues.
- Inventory can be destroyed due to natural disasters or other disasters like fires. Cash or inventory can be stolen.
- Working capital is calculated assuming all obligations etc., are known. So often, it can be miscalculated if an asset or liability is missed.
What is Working Capital Management
Working capital management refers to decisions taken to ensure that the company makes to make sure it’s using its assets and liabilities to the best of the business’s ability.
Three parameters that working capital management include:
- Capital ratio: This parameter is calculated by dividing current assets by current liabilities. If the ratio is below 1, that can indicate that the company is struggling to meet short-term obligations. Keeping a working capital ratio between 1.2 to 2.0 is desirable. But if the working capital ratio exceeds 2.0, that’s an indicator that the company isn’t using its assets effectively.
- Collection ratio: This is calculated by multiplying the number of days in a considered period of time multiplied by the average amount of outstanding accounts receivable divided by the total amount of credit sales during the considered period. The collection ratio gives the company an idea about the number of days the company takes to receive payment.
- Inventory turnover ratio: This measures how fast a company’s inventory is being used in sales and replaced. This ratio can also compare the company to competitors and peers. If the ratio is too low, the company’s inventory might be too high, and if the ratio is too low, the company’s inventory might be inadequate. The inventory turnout ratio is calculated by the cost of goods sold divided by the average balance sheet inventory.
We have outlined only answers to the most common question regarding working capital. It is pretty simple to learn what it is; however, it will be necessary to take time to calculate it properly. So it is wise to hire an accountant or any other financial advisor who has experience in this type of calculation.