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Working Capital: What Is It and Why Is It Essential Small Business?

Understanding Working Capital as form of business capital

Many small business owners ask, "What is working capital?" Here we cover the basics to help you understand working capital and why it's important.

Working capital can mean a lot of different things to a lot of different business owners. So we’ve put together a quick rundown to help you understand what it is and how to get it working for you:

What Is Working Capital?

Most business owners will be familiar with working capital (often abbreviated as WC). If you’re asking “What is working capital?” it refers to the difference between current assets and its current liabilities as found on a business balance sheet. In this sense, current assets are basically anything that a business owner can turn into cash within the next 12 months. Liabilities are the costs and expenses a business incurs within that same period.

Examples of current assets include accounts receivable, inventory, prepaid expenses, cash, cash equivalents and marketable securities. On the other hand, current liabilities include accounts payable, wages payable, income tax payable, interest payable and customer deposits.

Working capital is a reflection of current short-term financial health. It indicates whether a business has enough short-term assets to cover day-to-day operations and short-term debt. But, while similar, WC and cash flow aren’t the same. Both are critical measurements of financial health. Working capital is a snapshot of a present situation, while cash flow measures the ability to generate cash over a specific period. Most businesses with high cash flow will also have high working capital. But there can be some divergence depending on things like investments, paying off old debt and paying dividends to shareholders. Once you know your current assets and current liabilities, you can calculate the working capital formula:

WC = current assets current liabilities.

The difference between current assets and current liabilities is sometimes called net working capital.

Assessing Your Working Capital Needs

Generally, a business will want a positive WC ratio (Current Assets/Current Liabilities). While, in theory, a business with a working capital ratio of 1.0 should be able to adequately meet all of its short-term expenses, most businesses (and analysts, banks, accountants etc.) will like to see that number slightly higher. Excess WC will give a business a kind of ‘cash cushion’ against unexpected expenses and can be reinvested back into the business to help fuel growth. However, a ratio below 1.0 indicates current assets aren’t enough to cover short-term debt and could potentially mean a business needs additional business capital.

A ‘healthy’ working capital ratio is generally considered to be somewhere between 1.2 and 2.0. This shows sufficient short-term liquidity and good overall financial health. But if the ratio is too high, it could also be a problem. While not exactly a ‘bad’ problem, a ratio higher than 2.0 could mean a business isn’t making the most of its excess cash and assets by actively investing them into expanding the business. This may indicate poor financial management and missed business opportunities.

How to Manage Your Working Capital

The amount of working capital a business needs to run smoothly will vary depending on a range of factors. These include business type, operating cycle as well as current and future growth goals. While large businesses can get away with a negative working capital ratio for a short-term (because of their ability to raise funds quickly), small to medium businesses need to actively maintain a healthy level of WC.

Certain business types will have a higher working business capital requirement than others. Retailers, wholesalers and manufacturers, for example, all have physical inventory. Manufacturers need to purchase raw material, produce and then sell their products. This often requires a lot more working capital. On the other hand, businesses that provide intangible services, like consultants or online designers, generally have much lower working capital needs. Also, mature businesses that have already gone through their growth phase and are no longer looking to grow rapidly won’t have high working capital needs.

Many seasonal businesses will have much higher working capital needs during certain periods of the year as they prepare for their busy season. The length of the operating cycle of a business can also have an effect on how much working capital they need. Businesses that take longer to make and sell a product will need more business capital in the interim periods. So will businesses with slow-paying customers.

Understanding all the different factors that can affect your WC needs is the first step to managing healthy finances. If your business is seasonal, anticipating when you may need a cash injection and how much can help smooth short-term liquidity challenges. If you have customers who are slow payers, you may need to adjust spending to compensate for a period of cash shortage until the payments come in.

One tool you can use to manage working capital is a cash flow statement. You can also get helpful tips in Cash Flow Management: Why It’s Crucial for Business Success.

Even if you are looking to expand or grow rapidly, you will have increased capital needs on top of any funds dedicated to expansions (i.e. new shop, equipment etc.).

Small Business Finance Solutions

A report by Digital Finance Analytics found that around 60% of SMEs are looking to borrow and that most are looking for WC support. The report found that the main driver for this was delayed payments over the standard 30 days (particularly from large private sector companies and government agencies). It also found that the average debtor period is more than 50 days and rising.

Xero’s Small Business Insights (a report that analyses Australian business data) found that at least half of all Australian SMEs are cash flow negative throughout the year. This number varies a bit throughout the year. However, more businesses are cash flow negative in the months leading up to Christmas and into January.

Understanding Working Capital | Moula Good Business www.moula.com.au

All these findings reaffirm the importance of a healthy WC ratio in any business. They also show that many businesses need support with business capital. This isn’t necessarily because they’re ‘bad’ businesses. In fact, it’s usually quite the opposite.

Many businesses with cyclical sales cycles use regular short-term working capital loans to bridge the gap in customer payments or to help out during slow times. Businesses that take out these short-term loans aren’t in debt or have cash flow problems, but they look to maximise profits. They also take out loans during the lead-up to their busy periods (or as they’re anticipating repayments). Then they use the additional business capital to increase sales and, subsequently, profits. They then repay the loan quite easily once all their sales are finalised.

Understanding your unique WC needs may be a bit tricky at first. But once you do, it goes a long way to ensure your business runs smoothly.

Author:

All the thoughts, ideas and musings from the Moula team! Covering everything from work/life balance to general finance tips plus everything in between!

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