Our Comprehensive Guide to Understanding Working Capital
As an entrepreneur, you may hear the term working capital and wonder what it means and how it can be beneficial for your business. Let’s take a closer look at this term and its impact on entrepreneurs.
What is working capital?
Working capital is a financial measure that reflects the difference between your business’s current liabilities and current assets. It’s the number of funds that are available for your business to use to manage your day-to-day operations. Whether you are a sole proprietor or are incorporated, working capital can be a valuable measure when it comes to assessing your business’s short-term financial health.
How do I calculate my business’s working capital?
To calculate this financial measure, you will use the working capital formula: your business’s current assets divided by your business’s current liabilities.
Your business assets are what your business currently owns that can be easily turned into cash within one business year or 12 months. Business assets include chequing and savings bank accounts, as well as investments like stocks, bonds, mutual funds, and exchange-traded funds (ETFs). It also includes cash flow, accounts receivable, and the estimated value of your inventory. Current assets do not include investments like real estate, hedge funds, or collectible items.
Your business liabilities are what your business currently owes, including debt and expenses, within one business year. It includes operational costs like rent, utilities, materials, and supplies. It also covers accounts payable, short-term borrowings like a business loan, and accrued liabilities like accrued interest payments or accrued wages.
For example, say your business’s current assets are $100,000 ($30,000 cash flow, $20,000 accounts receivable, and $50,000 inventory value). And your current liabilities are at $50,000 ($30,000 accounts payable, $5,000 short term borrowings, and $25,000 accrued liabilities).
Using the net working capital formula, $100,000 divided by $50,000, your business currently has a net ratio of two for working capital. This means you have $50,000 in net working capital available.
What is positive and negative working capital?
Positive working capital is a ratio of anything above one. A ratio of above one means your business has the ability to pay off its current liabilities using its current assets. It also means your business has a healthy amount of cash flow, where you can afford your day to day expenses without going into major debt for at least 12 months of operation.
So, for example, if you have a ratio of two for net working capital, this means you are in a strong financial position as a business.
Negative working capital is a ratio of anything below one. A ratio of below one is an indication that your business is struggling to manage its day-to-day expenses and debt. It also means your cash flow is stalled or weak, and you run the risk of your current liabilities overtaking your current assets, a worrisome sign for potential investors and funders.
Though negative working capital is often a detriment for entrepreneurs and small business owners, for major corporations and chains, it’s more manageable. This is because corporations like Walmart or Mcdonald’s are able to maintain a steady cash flow due to a high turnover of their inventory and fast payment from customers. They require less working capital than a small business because they can generate capital, often a lot of it, in a short period of time.
Does my business’s working capital change over time?
Yes, in fact, your business’s working capital calculation is not a static amount that stays the same throughout the year. It uses current numbers, and it should be treated as a short-term calculation that will likely change.
To get a better sense of your business’s working capital, and have a big picture view of your finances, calculate it month by month. Put your current assets and liabilities into the working capital formula at the same time each month and plot it out to see how the ratio fluctuates.
These calculations can help you identify which months have more working capital, and which months have less. It will help you pinpoint the ups and downs of your cash flow and notice which months have the widest gaps in available working capital. You can then make some educated predictions around which months or periods of the year will be your most profitable and where you may need to plan for more working capital to ensure your business stays healthy and financially secure.
An entrepreneur who sells handmade products, for example, may plot their working capital month-to-month and notice high cash flow during the holiday months, and then less cash flow in January and February. With this information, the entrepreneur can then plan to have more working capital set aside for less profitable months, so they are able to afford to stay in business and potentially grow.
What are the benefits of having working capital?
One of the major benefits of working capital is that it allows you to ride through seasonal changes in your business. Depending on your industry, you may experience more cash flow during a busy season, such as the holidays or the summer months, and have less money coming in during slower months of the year. If you need additional support during busy months, you can also use working capital to hire temporary employees or to cover unexpected expenses that may come up.
Working capital gives you a financial cushion to lean on so you can stay operational during less busy months without having to take on more debt.
Another benefit of working capital is that it gives you the ability to grow your business in a sustainable way. You can use it to pay off any debts or payments owed to suppliers, employees, or the government at tax time while you wait for payments from customers or vendors to come through. This can help you avoid late payment fees or high-interest rate payments and keep your business healthy financially. It can also help you improve your business by being able to take advantage of buying inventory in bulk and getting supplier discounts, which will keep your bottom line healthy and sustainable.
Having positive working capital also makes your business more attractive to potential investors and vendors. If an investor sees you are operating at a high working capital ratio for most of the year, they will likely be more inclined to see your business as a viable investment with lots of growth potential.
How can you increase your business’s working capital?
If you notice your business’s working capital is falling into the negative ratio zone, don’t worry. There are a couple of ways you can increase your net working capital, so it sits in the positive zone.
One option is to apply for a business line of credit with your bank that is unsecured and revolving. Though business credit cards are great for small business expenses, they are not recommended for use as working capital. They often have a high-interest rate and can lead to an accumulation of debt. Lines of credit will have lower interest rates than a business credit card and can be a great way to finance temporary working capital needs with very low risk. You can also put a limit on the line of credit, so you do not over-borrow or spend outside of your means.
To qualify for a business line of credit, you will need to show that your business is in good financial standing. Your bank will look at your current working capital ratio, your annual revenue, your assets, and your liabilities, as well as your projected growth as a business. Most banks will offer a line of credit that is no more than 10 per cent of your business revenues, a healthy amount that won’t put you at risk of borrowing more than you need.
Another way you can grow your business’s working capital is to reduce your liabilities, so they are more manageable and aren’t as high as your assets. Take a closer look at your business liabilities and identify possible ways you can reduce or streamline certain expenses so you can get to a positive working capital ratio and focus on growing your business in a healthy way.
We hope our guide to understanding working capital has given you the information you need to manage your business finances and become more knowledgeable as an entrepreneur.
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This article offers general information only and is not intended as legal, financial or other professional advice. A professional advisor should be consulted regarding your specific situation. While the information presented is believed to be factual and current, its accuracy is not guaranteed and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author(s) as of the date of publication and are subject to change. No endorsement of any third parties or their advice, opinions, information, products or services is expressly given or implied by Royal Bank of Canada or its affiliates.