Understanding Working Capital: What It Is and Why It Matters?

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Working capital is a measure of a company's financial health and is essential for the day-to-day operations of a business.

Understanding Working Capital: What It Is and Why It Matters?

Learn about what working capital is, how it is calculated, and why it is important for the success of a company. Find out how to increase your working capital and improve your company's financial health.

Liquidity is a small business's lifeblood. Most of our clients use the profits from SBA 7(a) loan proceeds to jumpstart business expansion.

Here’s what you need to know about calculating current assets, and how it can help your business grow.

Working Capital Formula

Working capital is the difference between the total value of a business's assets and liabilities. It's a measure of liquidity and can be used to determine how much money a company has available to pay its debts or make investments.

It is the amount of money a company has at its disposal to finance its operations. It's made up of both cash and other assets, such as inventory and receivables. The net current assets ratio is a measure of how much cash a company holds compared to its current liabilities.

Working Capital Management

Working capital, also known as Net Working Capital (NWC) is the difference between current assets and current liabilities.

Current assets, as per the Small Business Administration’s website, are the most liquid of your assets. Cash held in a business checking or savings account is seen as liquid since it can be quickly withdrawn to pay obligations. Real estate investments are an example of a non-liquid asset because it can take months to collect the proceeds from a sale.

Current liabilities are any obligations due within one year. What remains after deducting current liabilities from current assets is referred to as working capital. This number may be either positive or negative. It represents the kind of security you can provide for your immediate debtors.

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  1. How is working capital calculated?

    Working capital = current assets – current liabilities

    Your balance sheet can be used to calculate current assets. According to the SBA, a balance sheet is a list of a company's assets, liabilities, and owner equity as of any given date.

  2. Positive vs. Negative working capital

    It is important to know if you have enough capital or if your business is lacking.

    If a company has enough cash, accounts receivable, and other liquid assets to meet its short-term liabilities, including accounts payable and short-term debt, it has a positive cash balance.

    If a company's current assets are insufficient to meet its short-term debts, it has a negative cash balance.

  3. Why is working capital important?

    It is important to have positive cash flow so you can fund operations and meet short-term obligations.
    If a company has enough liquidity, it can continue to pay its employees, suppliers, interest payments, and taxes. Additionally, current liquidity might aid in minimizing income volatility.

  4. How can you use working capital?

    It can be used in a variety of ways. Examples include purchasing inventory, launching marketing initiatives, hiring employees, paying taxes, and unexpected expenses.

  5. Why do you need working capital?

    It is a daily necessity for businesses, as they require a regular amount of cash to make routine payments, cover unexpected costs, and purchase basic materials used in the production of goods.

  6. How is working capital used?

    Money is used to cover all of a company's short-term expenses, which are due within one year. Operating capital is the difference between a company's current assets and current liabilities. Liquidity is used to purchase inventory and pay the short-term debt, and day-to-day operating expenses.

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Positive Working Capital

Positive working capital occurs when a company's current assets exceed its current liabilities. In other words, it is when a company's short-term assets are greater than its short-term debts. Positive working capital is generally considered to be a sign of financial health, as it indicates that a company has the resources it needs to meet its short-term obligations and fund its day-to-day operations.

There are a few factors that can contribute to positive working capital, including:

  1. Strong sales: A company with strong sales is more likely to have positive cash flow, as it is able to convert its assets, such as inventory and accounts receivable, into cash more quickly.
  2. Effective inventory management: A company that is able to manage its inventory efficiently is more likely to have positive operating capital, as it is able to turn its inventory into cash quickly.
  3. Short-term debt management: A company with a low level of short-term debt is more likely to have a positive cash balance.
  4. Good credit terms: A company with favorable credit terms, such as a long payment period, is more likely to have positive operating capital.

It is important for companies to maintain an appropriate level of working capital, as having too much liquidity can indicate that a company is not effectively using its resources while having too little operating capital can put a company at risk of financial difficulties.

Negative Working Capital

It occurs when a company's current liabilities exceed its current assets. In other words, it is when a company's short-term debts are greater than its short-term assets. Negative working capital can be a sign of financial distress, as it indicates that a company does not have enough liquid assets to meet its short-term obligations. Companies with negative working capital may have difficulty paying bills or loans on time, which can lead to financial problems.

There are a few reasons why a company might have negative working capital, including:

  1. Rapid growth: A company that is growing quickly may have a negative cash balance as it invests in assets and expands its operations.
  2. Short-term debts: A company with a high level of short-term debts, such as payables or short-term loans, may have negative liquidity.
  3. High inventory levels: A company with a large amount of inventory relative to its sales may have a negative cash balance.
  4. Slow sales: A company with slow sales may have negative operating capital if it is unable to convert its inventory into cash quickly enough to pay its bills.

It is important for companies to manage their current assets carefully, as a negative cash balance can put a company at risk of financial difficulties. Some strategies for improving liquidity include reducing expenses, improving cash flow, and optimizing inventory management.

Here are a few more things to consider about working capital:

working capital
  • Liquidity can be used to fund a company's day-to-day operations, such as paying employees, purchasing inventory, and maintaining equipment.
  • A company's current assets can be affected by a number of factors, including its sales volume, credit terms, and inventory management.
  • A company with low liquidity may have difficulty meeting its short-term obligations, such as paying bills or loans, which can lead to financial problems.
  • Some companies may choose to use short-term loans or other forms of financing to increase their cash balance, while others may focus on improving their cash flow or reducing their expenses to increase their working capital.
Working Capital Loan

Short-term liquidity is available from online lenders, banks, and credit unions. Additionally, some companies that service small businesses, like PayPal® and Amazon®, are entering the lending space.

Startup Business Loan

Banks and credit unions are options for established businesses with collateral and strong credit, while online lenders may provide options for borrowers with varied credit histories.

  • Business credit cards
  • Invoice financing/factoring
  • Line of credit
  • Merchant cash advance
  • Bank Term loans
  • Small Business Administration (SBA) 7(a) loan
Conclusion

Don't let a low working capital balance hold your business back. Contact us to learn about financing options that can help increase your working capital.

Also Read: Why SBA 7(a) Loans are most popular

Meet Amit Ahuja, a passionate and driven individual with a multifaceted interest in business and finance. Amit's curiosity for the world of commerce knows no bounds, as he eagerly delve into market trends, investment strategies, and entrepreneurial success stories. Always on the lookout for opportunities to grow his knowledge, Amit avidly follows financial news and actively participates in networking events to gain insights from industry experts.

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