Working capital is the difference between your company’s assets and short-term liabilities. It measures your company’s operational efficiency, liquidity, short-term financial health, and how much your business has on hand to cover daily operating expenses.
You can calculate your working capital by using this formula:
Assets – Liabilities = Working Capital
Once you know your working capital, you can use this to measure your growth and guide your purchasing decisions. Potential lenders, investors, and business partners will also look at your working capital to gauge your business’s financial stability and creditworthiness.
When you look at the formula, it seems as if there are only two components to get the working capital. However, it’s more complicated than that.
There are four major components that you should know when calculating your working capital:
- Cash and cash equivalents
- Inventory
- Accounts receivable (AR)
- Accounts payable (AP)
In this article, we’ll look at each of the components to better understand working capital.
1. Cash and Cash Equivalents
Liquidity is an important factor of working capital, and cash is the most liquid asset of all. A cash reserve is an asset that provides you with the resources to cover day-to-day expenses, and this cash could mean money in the bank or physical bills.
On the other hand, cash equivalents are assets that can be liquidated easily without losing value. These include the following:
- Treasury bills (T-bills): This refers to a short-term debt obligation backed by the U.S. Treasury Department and have a maturity of one year or less
- Stocks and bonds: Company shares that you can freely trade on the stock exchange
- Money market accounts: This is another form of bank savings account with higher interest rates and more stringent minimum balance requirements compared to a regular savings account
- Exchange-traded funds: A type of mutual fund that’s more liquid than other funds
- Certificates of deposit: A savings account that you don’t touch until it reached a maturity level between three months to a year
2. Inventory
Inventory falls under current assets, making it an essential component of working capital calculations. The key is to practice good inventory management so you can stay on top of your inventory, from raw materials to finished goods.
Proper inventory management involves timely inventory purchases to avoid overflow, proper storage, and efficient utilization to maintain a smooth flow of finished goods to meet customer demand. At the same time, it also avoids excessive inventory purchases, tying your working capital to unsold goods. This delay in the cash conversion cycle can put a dent in your cash flow, impacting your business’ profitability.
Here are some of the methods to use to effectively manage inventory:
- First-In, First-Out (FIFO) Inventory
- Last-In-First-Out Accounting
- Weighted Average Method
Choosing one of the methods above can impact the current assets your business reports and, as a result, affect the working capital as inventory.
3. Accounts Receivable
Accounts receivable (AR) are another important factor you should consider when calculating your working capital. AR refers to the money owed to your business, like checks that haven’t been cashed or money that you haven’t collected. Once you’ve gotten the payments, the money you receive falls under the cash category.
Here are some of the examples of AR that you should include when calculating your working capital:
- Open invoices: These are the 30, 60, or 90-day invoices you give your customers to pay their debts. This process is referred to as the AR cycle because you know you have money to collect in the future, so the invoices should fall under the asset column.
- Accrued interest: You should also include all the interest you charge, even if it isn’t indicated on the customer invoice.
- Outstanding credit: Some businesses choose to extend credit to other businesses to foster a mutually beneficial relationship in the future. This is considered an asset until the businesses repay the credit.
4. Accounts Payable
After adding your assets, the last component you need to know is your business’ accounts payable (AP). When calculating your AP, include the liabilities that you’re going to owe within the year. To make this process more efficient you should automate your AP process.
Here are the following examples of accounts payable:
- Unpaid dividends: Some companies give investors a portion of the profits in the form of dividends.
- Supplier or vendor invoices: Include the expenses that haven’t been remitted to suppliers and vendors for goods and services you received.
- Debt repayments: This composes the principal and interest payments that go towards loans, mortgages, lines of credit, and other borrowed money.
- Operational costs: This varies depending on your business, but operating expenses may include payroll, utility payments, leases, materials, and more.
- Upcoming tax repayments: Include the tax payments you expect to make within the year.
How to Boost Your Working Capital
Ideally, all four components of working capital should work together to create a healthy cash flow balance. Otherwise, you’ll lack the financial resources to meet working capital requirements. It’s important to know the different ways to cover your expenses while managing your liabilities and assets.
Here are some of the ways you can add to your working capital:
- Working capital loans: You can apply for working capital loans from alternative or traditional lenders.
- Business credit cards: These are one of the most convenient funding methods, but business credit cards usually come with high fees, interest rates and demand a high credit score.
- Personal assets: It can be tempting to use your 401(k) or home equity to fund your business. However, you need to be aware that there’s a chance you could lose these assets in case of a default. Assess your situation and carefully consider whether you’re willing to take this risk.
What’s Next?
Working capital is the lifeblood of any business because you won’t be able to pay for day-to-day operating expenses without it. If you’re aware of the major components of working capital, you’ll know the ins and outs of your finances, and you’ll be able to think of ways to keep your business profitable.