Working capital is a financial liquidity indicator that measures your company’s short-term financial health. Beyond being an important tool for figuring out how to grow and scale your business, it could be used by shareholders and investors to make financial decisions about your company.
What you need to know
- Calculate working capital by subtracting short-term liabilities from your current assets.
- You can improve your current assets by boosting cash flow management and AR efficiency.
- Using a business checking account that has all the tools you need can help you manage cash flow more effectively, giving you more working capital.
Understanding working capital
Working capital is calculated by subtracting your current liabilities from your current assets. Examples of current liabilities (also known as short-term liabilities) include accounts payable and debts. Current assets are cash and cash equivalents, accounts receivable, and raw materials and finished goods inventories. These should all be listed on your balance sheet.
A current (or working capital) ratio is calculated by dividing current assets by current liabilities. The quotient in that equation is then expressed as a decimal to give you a measure of your company’s liquidity. A good working capital ratio should be between 1.5 and 2.0, meaning you have one and a half to two times what you need to pay your bills.
The importance of knowing how much working capital you have should not be underestimated. This number tells you what you can afford to spend after meeting your short-term financial obligations, which can help you manage payables and receivables, as well as give you a critical data point for financial planning and analysis (FP&A).
Assessing your working capital
Don’t be alarmed if you get a negative total the first time you calculate working capital. Current assets optimization and/or reducing short-term liabilities can help you correct that problem.
Improving accounts receivable efficiency and implementing better cash flow management processes can easily improve the asset side of the ledger. Reducing liabilities is more complicated. You’ll need to evaluate each invoice in your accounts payable file to determine where cuts can be made.
The particulars of this exercise will vary, depending on which stage of development your company is in. Capital efficiency will be your primary focus if you are going into a growth period. Financial stability becomes the priority if you are contemplating an exit. Make sure you know your goals when you start the working capital assessment.
Strategies to increase working capital
You can increase your assets or decrease your liabilities to increase your working capital. Improving accounts receivable processes is one way to do this. That could mean changing payment terms (ex., net-60 to net-30) to bring money in faster. You might also want to check overdue invoices to see who’s not paying you on time.
More efficient inventory management is another way to increase working capital. Don’t buy or manufacture more than you can sell. If you run a retail or e-commerce business where consumer tastes change frequently, focus on moving your products off the shelves faster—you don’t want to get stuck with inventory you can’t sell. Buy or make less, and lower your prices if you need to.
These changes to inventory management and raw material orders can significantly reduce short-term liabilities. Think of yourself as a cook: You want to make enough to feed everyone, but you don’t want to have any leftovers.
Finally, you could negotiate better terms with suppliers. This could allow you to increase working capital without harassing your clients for payments or laying people off because of cutbacks in production. Make a few phone calls and discuss bulk pricing or lowering minimum order quantities (MOQs). Most suppliers are already having those conversations with others in your industry.
Managing cash flow effectively
Cash flow is the lifeblood of every company. Streamlining the way you manage it can lead to working capital cycle improvement. For instance, selling real estate instead of holding it for a tax credit improves liquidity. That extra cash on hand can be used to pay off short-term liabilities, effectively improving your business’s current ratio.
Your business checking account and your expense management platform are two of the most important tools for cash flow management. Connecting both to your accounting software and automating the data flow allows you to instantly see where your business funds are being spent and how much revenue is coming in daily, weekly, or monthly.
Create and stick to your budget, then review it frequently because costs are always changing. According to the United States Bureau of Labor Statistics (USBLS), inflation was over 6% in 2022 and at least 5% for half of 2023. Have you reconciled your budget to those increased costs? If not, you might want to look at it again.
Properly managed cash flow can translate into more working capital for your business. At the very least, you’ll be able to see where expenses can be cut and which revenue streams should be improved. A cash flow analysis can uncover these and other issues, allowing you to meet your business capital requirements.
Exploring financing options
You can also add credit management to cash flow management to improve your working capital ratio. Short-term business funding can be obtained with a term loan or business line of credit. Both business finance solutions can improve your short-term cash flow, but they also come with a cost that will need to be factored into your working capital equation.
Funds from a loan or line of credit are an asset. The money paid out in monthly loan repayment or interest on a business line of credit are liabilities. You need to include both when you calculate working capital. It’s critical always to include the asset’s cost if there is one, or your final numbers won’t be accurate. That could be a big problem.
Mitigating risks in working capital management
Assuming you have enough working capital because your profits look good is a common mistake. Profit numbers can be manipulated. Like cash flow, working capital is based on an equation that leaves no room for error. Current assets and current liabilities are numbers reported on your balance sheet. They’re unlikely to be wrong.
You’ll also want to avoid several mistakes when applying for a working capital loan. One is not having a solid business plan, as lenders will likely ask you what you’ll use the money for. If you’re not prepared, they may see you as high risk and refuse to give you a loan.
Two other risks to your business are market fluctuations and economic downturns. Liquidity is your best defense against both. Keep enough cash to weather the storm when it comes. If you’re investing your cash elsewhere, try to have a healthy balance of short-term and long-term assets. In other words, make sure you can sell what you own quickly, if needed.
Conclusion
You can maximize your working capital by improving the accounts receivable process, negotiating with vendors for better prices and terms, and managing your inventory more efficiently. Evaluating cash flow using online banking, expense management, and accounting tools can help you increase revenue and/or cut expenses.
Common errors you’ll want to avoid are assuming you have enough working capital and taking out a loan without a plan to use the funds. Work on solving working capital problems internally through cash flow management before applying for business financing. Begin that by calculating your working capital ratio. Follow up with regular budget and accounting reviews.
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