Beth Whitmore explains the concept and importance of working capital to entrepreneurs.
There are numerous ways to measure the financial health and the success of your start-up business. A growing customer base and profit can be a fair indication of success, but you also need to understand the importance of your cash flow.
Having a full understanding of your working capital will give you a useful insight into your business and what’s needed in terms of money to finance your day-to-day operations. If you’re just starting or have been trading for some time it’s essential to get a good grasp of this and understand what’s required to keep your organisation afloat.
So, it’s time to get to grips with the working capital formula because as this post will demonstrate, the future of your business is dependent on it.
What is working capital?
Working capital gauges an organisation's health and refers to the funds required to fulfil its everyday financial obligations. These commitments will be essential to the day-to-day working operations of the business, some of which include:
Payment of salaries
Reimbursement of suppliers
What is working capital formula?
The working capital formula measures the short-term financial health of a business. It enables you to check if you have enough money available to meet financial obligations on a short-term basis. This is the working capital calculation: Working capital = current assets - current liabilities.
The principal works on the basis that you have cash coming in via payments from customers for example (current assets), and money going out on things like IT support and telecoms etc (current liabilities).
Be sure to read our post on the sales ledger and the purcahse ledger for more on this. Your business will need to generate a regular amount of cash to make these routine payments and cover unexpected costs.
Without a positive cash flow, you simply won’t be able to cover your costs (let alone make a profit) resulting in eventual business failure. You’ll also need a substantial amount of working capital to deal with any unexpected emergency.
The formula allows you to gain an understanding of your cash flow situation for your management accounts. A positive working capital means that you’re able to pay off short-term liabilities. Whereas, a negative working capital means that you’re unable to meet your debts.
Cash flow problems are one of the leading causes of business bankruptcy, so it’s crucial you both understand and monitor yours carefully. Ask yourself:
Do you know what your current cash flow looks like?
What do you expect your cash flow to look like in six months time?
If you can’t answer both of those questions, then perhaps you’re not as in control of your organisation as you should be!
How to calculate the working capital ratio?
The working capital ratio is how many times a business can pay off its current liabilities through use of current assets. A ratio of less than one means the likelihood of financial difficulties! The calculation is: Working capital ratio = current assets/current liabilities.
What is my working capital requirement?
New businesses often find themselves struggling to identify how much working capital they need when starting out. Unfortunately you’ll find it fluctuates regularly as your needs are likely to change.
Most businesses will incur costs to resource the production and/or delivery of their products/services. This is the result of suppliers often needing to be paid before you are reimbursed by your customers. House builders, for example, have to purchase materials such as bricks, blocks, doors, and windows in order to build homes to sell on the market.
This is known as the operating cycle or cash flow cycle. It’s important you understand that your funding requirements are dependent on the length of your cash flow cycle. This represents:
The time duration for your product/service to be created and provided
How long it takes for invoices to be raised for said products/services
The period of time to receive payment from customers
The working capital requirement therefore is the amount of finance you need to cover this time delay. Remember, the longer you cash flow cycle the more capital you’ll need which highlights why it's so important to put payment collection policies in place to ensure you're reimbursed by customers promptly.
Be sure to track your cash flow on a monthly or even weekly basis. This will give you a good idea of when and how much funding your business needs. Also you should account for quarterly VAT and annual corporation tax payments. Ideally these will be in separate savings accounts so that you don't view it as spending money.
An accurate cash flow forecast will allow you to see what’s happening to your working capital, ensuring you make better informed financial and investment decisions!
This post was created on 30/09/2016 and updated on 20/05/2020.
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