One of the financial metrics that many companies rarely calculate and use is their level of working capital.
By definition, working capital is the company's current assets minus its current liabilities as listed on the most recent balance sheet. Current assets are cash, accounts receivable, inventory and any short-term company investments. Current liabilities are vendor payables, short-term loans and any other accrued expenses like wages or interest.
Determining a company's level of working capital is one way to monitor a company's cash management and short-term financial health. Without enough working capital, a company may not be able to pay its employees, vendors, lenders or make the investments they need to grow their business.
A positive working capital number means the company has enough cash or liquid assets to pay off all short-term liabilities. It also shows that it has positive cash flow which can eventually give the company the money to grow faster. A negative working capital means the company may not have enough cash to pay all their short-term debts, which can limit its ability to sustain their business.
A Company's Working Capital Needs
To determine this, check another metric that is closely related to working capital—the current ratio for the company.
A company's current ratio is defined as the ratio of current assets divided by current liabilities. A current ratio over one means there is enough short-term assets to pay any short-term business liabilities. A ratio over two indicates current assets are at least twice current liabilities. (This is the target for many businesses, but standards can vary by industry.)
If the current ratio is less than one, it means that any current liabilities being paid are costing the company more money than the assets they are bringing in. Typically, companies with a working capital ratio of less than one also have trouble paying their bills over time.
Exactly how much working capital a company needs to grow depends on how fast they want to build their business and what the target current ratio is.
For example, a company has $200,000 of current assets and $150,000 of current liabilities with target current ratio of 2. If it wants to grow 35 percent in the next year, then working capital will need to be increased by $202,500 in the next 12 months. Working capital calculators such as ones from WorkingCapital.org and SurePayroll can help determine what is exactly needed.
Improving Working Capital
Having enough working capital in a business helps provide stability and growth. Here are a number of ways to improve the amount of working capital available.
- Increase profit by reducing expenses or increasing sales. This can help leave more cash in the business for increased current assets. A reduction of expenses can help lessen current liabilities over time.
- Lower debt payments. Consider refinancing any debt to a lower interest rate or over a longer period of time to reduce monthly payments. This can be done when credit cards or bank lines of credits are converted to term loans. Lower interest rates help reduce expenses and increase profit.
- Reduce inventory. While inventory is in the working capital calculation, many times it is not liquid at its cost price. Keeping less inventory and turning into sales will produce more profit and increase cash.
- Sell unused long-term assets. If these are not being utilized to generate profits in the business, consider selling or leasing them for cash and to help increase the company's working capital. For example, an unused piece of equipment or part of an office space can be sold or leased to generate revenue.
- Settle short-term debts for less than what is listed in accounts payable. Sometimes, short-term debts can be paid for less than originally planned. This could be in the form of a reduction for paying a vendor early. Doing this can help reduce costs and increase profits.
- Negotiate better pricing with suppliers. Review all supplier contracts and negotiate better pricing if possible. Consider finding alternate vendors who have similar products at lower prices. This can also help reduce costs and increase profits.
But keep in mind that these strategies only work if a company keeps its financial statements up to date so they can have a clear picture of their financial position at all times and what changes should be made. It's important to track your working capital calculation trend over time to see if it is going up or down, in addition to reviewing monthly profit and loss statements, balance sheets and cash-flow statements.
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