Understanding your business' working capital is a crucial part to running an enterprise – no matter its size. But despite this, it's a pretty simple concept.
In short, working capital is the total amount of a business’ current assets minus the total amount of its current liabilities.
To break that down a bit, current assets might include cash, accounts receivable (money owed to the company) and all of your stock – whether that be raw materials or goods ready for market. Current liabilities can include anything you legally owe others, such as outstanding invoices, taxes, wages and other expenses, like paying back a loan. The phrase working capital is also known as net working capital (NWC).
The concept is a useful one to bear in mind as it determines the amount of money a business has at its disposal to pay for any immediate expenses. In other words, it is the organisation’s ability to pay its current liabilities and any additional investment with its current assets.
Lenders use working capital to measure whether a business is in good financial health, and whether it is likely to be able to pay off debts within a 12 month period. Positive working capital can help businesses to pursue new opportunities and investments, which could help in their long term growth.
As mentioned above, the formula for working capital is relatively simple:
Current assets – current liabilities = working capital
The working capital formula works by taking away the amount in liabilities from the amount in assets. For example, if a company has £25,000 in cash, £10,000 of accounts receivable and £45,000 in inventories, that would give them a total of £80,000 in current assets.
If this same company has accounts payable of £20,000, short-term borrowings of £10,000 and accrued liabilities of £10,000, they would have current liabilities of £40,000.
Using the working capital formula, this would mean subtracting the current liabilities (£40,000) from current assets (£80,000), resulting in a total of £40,000 in working capital.
While it is always preferable to have positive working capital, even successful businesses will encounter times when their working capital is negative. This is because assets and liabilities are assessed on a 12-month rolling basis, so if there are short-term expenses – such as a write-down of an acquisition, restructuring, or the purchase of a new office – this is likely to have a detrimental effect on the overall figure.
Businesses can take out a working capital loan for the short-term. This is usually done to ensure that the company continues to operate smoothly. Responsible loan providers will require any enterprise to be able to afford to borrow the funds.
Comparing the working capital of companies in the same sector can illustrate how competitive they are. For example, if Dave's Plumbing has a positive working capital of £50,000 that far outstrips that of its rivals – say, Jane's Plumbing, which has £15,000 and John's Plumbing, which has £5,000 – it means Dave's Plumbing could potentially invest with the goal of growing its business more swiftly than its competitors.
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The simple definition of working capital is subtracting how much a business has, with how much it owes, over a 12-month rolling period.
A positive working capital is always preferable, but even successful companies can get into a position of negative working capital.
Working capital is used by creditors, analysts and prospective clients as an indication of a company’s financial health. It helps them decide whether the company can pay off their debts, whether they are worth partnering with, and whether they are worth investing in.
There are many business loans available specifically designed to create a positive working capital.
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