Working Capital: A Guide for Non-Finance Business Owners
Working Capital Basics
For businesses to succeed during tough times or to grow without financial constraints, it is crucial to understand two key metrics: working capital and cash flow. Both metrics provide insights into a company’s financial health, with cash flow indicating the money generated or spent in a specific period, and working capital representing the difference between a company’s current assets and current liabilities.
Positive working capital implies that a business has the capacity to withstand financial challenges and can invest in growth after fulfilling short-term obligations.
What is Working Capital?
Working capital is the difference between a company’s current assets and current liabilities, as shown on its balance sheet. Current assets include cash, accounts receivable, and inventory, while current liabilities consist of accounts payable, taxes, wages, and interest owed.
Key Points
Working capital is the difference between current assets and current liabilities.
Positive working capital indicates a company’s ability to pay bills and invest in growth.
Managing working capital ensures the efficient use of financial resources while meeting daily operating expenses.
The Importance of Working Capital
Working capital serves to fund operations and fulfill short-term obligations. A company with sufficient working capital can continue paying its employees and suppliers, meeting interest payments and taxes, and navigating cash flow challenges.
Moreover, working capital can help fund business growth without incurring debt. Demonstrating positive working capital can make qualifying for loans or credit easier.
Benefits of Working Capital
Having adequate working capital helps businesses manage fluctuations in revenue, particularly during seasonal sales changes. For example, a retailer generating most of its revenue during November and December can use working capital to cover expenses throughout the year, such as rent and payroll. By analyzing and maintaining a sufficient working capital buffer, the retailer can stock up on supplies and plan for hiring temporary and permanent staff.
Working Capital and the Balance Sheet
Working capital is calculated using current assets and current liabilities from a company’s balance sheet, which is a snapshot of its assets, liabilities, and shareholders’ equity at a given point in time. The balance sheet categorizes assets and liabilities according to their liquidity and payment timeline, respectively.
Calculating Working Capital
Working capital is determined by subtracting current liabilities from current assets, as shown on the balance sheet.
Working Capital Formula: Working capital = current assets – current liabilities
Working Capital Example for a Small Manufacturing Business
The following working capital example is based on the balance sheet of a small manufacturing business, XYZ Manufacturing Co., as of December 31, 2024. All amounts are in thousands.
XYZ Manufacturing Co. listed current assets of $2,500 thousand and current liabilities of $1,800 thousand. Its working capital was therefore $2,500 thousand – $1,800 thousand = $700 thousand. That represented an increase of $200 thousand compared with three months earlier, on September 30, 2024, when the company had $500 thousand in working capital.
|
December 31, 2024 |
September 30, 2024 |
|
|---|---|---|
| ASSETS | ||
| Current assets: | ||
| Cash and cash equivalents |
$500 |
$400 |
| Accounts Receivable |
$800 |
$600 |
| Raw Materials Inventory |
$600 |
$700 |
| Finished Goods Inventory |
$400 |
$500 |
| Prepaid Expenses |
$200 |
$200 |
| Total current assets |
$2,500 |
$2,400 |
| Property, Plant, and Equipment | ||
| Property, Plant, and Equipment |
$5,000 |
$5,100 |
| Less: Accumulated Depreciation |
$2,500 |
$2,400 |
| Property, Plant, and Equipment, net |
$2,500 |
$2,700 |
| Other Long-term Assets | ||
| Other Long-term Assets |
$1,000 |
$900 |
| Total assets |
$6,000 |
$6,000 |
| LIABILITIES | ||
| Current liabilities: | ||
| Accounts Payable |
$900 |
$1,000 |
| Short-term Loans |
$300 |
$200 |
| Accrued Expenses |
$400 |
$300 |
| Current Portion of Long-term Debt |
$200 |
$100 |
| Total current liabilities |
$1,800 |
$1,600 |
| Long-term Debt, less amount due within one year |
$1,500 |
$1,700 |
| Deferred Income Taxes |
$300 |
$200 |
| Other Long-term Liabilities |
$200 |
$300 |
| Total liabilities |
$3,800 |
$3,800 |
Positive vs. Negative Working Capital
A company with positive working capital has enough liquid assets to cover its short-term obligations. In contrast, negative working capital suggests that a company may struggle to pay suppliers and creditors, raise funds for growth, or continue operations in the long term.
Components of Working Capital
Current assets and liabilities involved in calculating working capital usually include cash, marketable securities, short-term investments, accounts receivable, inventory, prepaid expenses, accounts payable, wages payable, taxes payable, interest payable, and other accrued expenses.
Working Capital Management
Working capital management is a financial strategy that optimizes the use of working capital to cover daily operating expenses and invest resources productively. Effective management of working capital enables businesses to fund operational costs and pay short-term debt.
Financial ratios, such as the working capital ratio (current ratio) and quick ratio, help assess working capital management and a company’s ability to meet short-term obligations.
Does Working Capital Change?
Working capital fluctuates for most companies due to factors like large outgoing payments or seasonal sales variations. The balance sheet captures a snapshot of working capital at a specific point in time.
6 Ways to Increase Working Capital
Businesses might need to increase working capital to cover project expenses or compensate for a temporary sales drop. Options for increasing working capital include:
- Taking on long-term debt.
- Refinancing short-term debt as longer-term debt.
- Selling illiquid assets for cash.
- Analyzing and reducing expenses
- Improving inventory management to prevent overstocking and potential write-offs.
- Automating accounts receivable and payment monitoring, which can boost cash flow and reduce the need to draw on working capital for daily operations.
Using Fiskl to Manage Working Capital
To effectively calculate and manage your company’s working capital, consider leveraging Fiskl’s comprehensive suite of financial tools and features.
Managing working capital with Fiskl’s financial software is essential for maintaining your company’s financial health. Positive working capital indicates that your business has enough liquid assets to invest in growth while meeting short-term obligations, like paying suppliers and making interest payments on loans.
Fiskl’s cash flow management tools allow you to track your company’s cash inflows and outflows, enabling you to make data-driven decisions to optimize working capital. With real-time financial reports, Fiskl provides a clear overview of your company’s financial performance, allowing you to easily monitor and manage your working capital.
Additionally, Fiskl’s burn rate feature helps you assess how quickly your company is spending its working capital, giving you valuable insights into whether you need to adjust your spending habits or seek additional funding.
Using AI-based automated accounting software like Fiskl for managing working capital ensures your business maintains a strong financial foundation. By offering cash flow management, real-time financial reports, burn rate tracking, and other relevant features, Fiskl empowers you to make informed decisions, optimize working capital, and set your business on the path to success.
