Working capital is an essential business asset – one that every organization needs to keep day-to-day operations afloat. Money management, however, isn’t every business owners’ strong point. In some cases bad forward planning can lead to a detrimental shortfall in working capital funds, putting the integrity of your organization at risk.
In this guide to keeping on top of working capital, we look at some of the most successful strategies used to calculate and maintain working capital cash flow. All of which can make the difference between your business successfully writing its financial future, or being one of the 50% of organizations to succumb to money troubles in its first five years.
What is working capital?
Working capital is fundamental for long-term business survival. Without it, businesses can quickly run up debts, and find themselves short of cash to cover essential overheads such as staff wages, equipment, utilities, rent and/or materials – all of which are vital in keeping day-to-day operations ticking over.
What exactly is working capital? Put simply, working capital is the value of liquid assets your business has at any one time. By which we essentially mean it’s the value of all of your business’s total assets minus its liabilities.
Business assets can be anything from cash in the bank, to physical equipment owned by your business, product stock, and materials. Whilst liabilities are the outgoings your business has to meet and include things like supplier invoices, employee wages and rent to your landlord for your business premises.
Why is it important?
Working capital is what keeps your business in profit and finances its continual operation, so it’s an essential aspect of organizational success.
Businesses that fail to accurately forecast their finances and manage their incomings and outgoings put themselves at risk of collapse. Working capital ensures that even if profits unexpectedly decline or you’re presented with an outgoing you hadn’t anticipated, you still have enough disposable financial assets within your business to stay in the black.
To accurately calculate working capital within your organization you need complete visibility over all of your business’s financial affairs. However, working capital management doesn’t just boil down to keeping accurate records of your company’s outgoing payments, expenses, and income.
To be successful at maintaining working capital long-term you also need to be accurate in your projections of the company’s finances in the years and months to come– and this is where the vast majority of working capital management in business falls down.
Let’s say, for example, your business has experienced sustained growth for its last three financial quarters. You might, theoretically, predict that growth is also guaranteed for the fourth quarter too, but what if that fourth quarter is when your business pays out most of its annual financial commitments? This would conversely impact on the amount of profit your company records in its fourth quarter and, had you not correctly forecasted for this in advance, you could be unexpectedly short of working capital.
The same applies to the physical assets your business owns which, as we know, contribute to the total value of your business’s working capital. Let’s say your products have a shelf life or your business follows seasonal trends. If you fail to sell your stock in time before it depreciates or goes out of date, then you might have to write off the cost of those assets, which again impacts your business’s working capital.
In these cases, working capital loans are available to help businesses recover from financial losses. However, the repayment of any such loan (plus its interest) will then be another financial commitment your business will need to factor into its outgoings.
The working capital formula and why you should use it
The best way to avoid slipping into the red, and having to turn to working capital loans for rescue, is by maintaining accurate records of your business’s net working capital in real time. This can be calculated via a simple formula, that takes into consideration your business’s total assets versus its current liabilities.
To illustrate as a mathematical formula:
Your business assets – your liabilities (outgoings) = your net working capital
So long as you keep accurate records of your financial incomings and outgoings via a business balance sheet you’ll always be able to use the above formula to calculate your company’s working capital.
For example, if your total business liabilities add up to £100,000 and your total assets equal £200,000 then your net working capital is £100,000.
We’ve deliberately used a very crude example to illustrate how the formula can be applied to calculate net working capital, but providing you have the total figures for both your business’s liabilities and its assets you can always quickly calculate your current working capital in this way.
As a key indicator of your organization’s financial health, it’s vital good business practice to be familiar with your net working capital balance. The higher the value of the liquid assets your business owns, and the lower its liabilities, the greater net working capital you will have. Giving your business a fighting chance of riding out any market uncertainty that may ensue, as well as raising its equity in the eyes of investors, shareholders, and stakeholders.
How to improve your working capital
The important thing to remember about working capital is that it’s never set in stone. That’s why it’s so fundamental to continually monitor this balance in real time and make adjustments whenever you see the value of your net working capital sliding.
Fortunately, if you are in a sales slump or quiet period, there are some actions you can take that will immediately improve your working capital, and consequently the financial health of your business.
1. Adjust your payment schedules
For your working capital to be sustainable it’s important to ensure that your outgoings don’t exceed your incomings at any given period in time. One way to correct this is by adjusting your payment cycles to guarantee your clients pay you before you need to pay your suppliers. If you can organize this cycle effectively you’ll essentially orchestrate a scenario where you’re receiving payment prior to making payments, helping to avoid negative equity or depletion in your net working capital.
2. Cut back on your outgoings
Another way to improve your working capital is by reviewing your business’s expenses and looking for areas where cost cutting can be accommodated. This might involve leasing equipment for your business premises, rather than buying it outright – saving you significant upfront expense and ensuring that you can cost-effectively upgrade your equipment as it depreciates. You could also consider hiring contractors to fill vacancies on your team rather than a salaried employee, renting shared office space or, if you own your office, renting part of it out to recoup some of the monthly overheads.
3. Reduce your stock or inventory
While inventory may be regarded as an asset owned by your business, unsold stock, or stock which you have to destroy because it’s exceeded its expiration date, counts as a liability. Each of which detrimentally affects your net working capital. Instead of holding vast quantities of inventory in-house, cost savings can be made by partnering with an external supplier who can supply you with stock on a needs-only basis. This ensures you receive stock at a sustainable rate and prevents over-investment into inventory which you’ll fail to see a return on.
4. Take out a working capital loan
If you really are in a bad place with your working capital, it may be worthwhile taking out a short or long-term loan to help you get back on your feet. Working capital loans are available on a range of term lengths and with varying rates of interest. It’s important to take time to familiarise yourself with the repayment schedule and the total value of any working capital loans you take out, to ensure you can comfortably afford the repayments. For your personal protection, and that of your business, you should also only lend from a reputable institution that’s financially underwritten and regulated.
Managing your net working capital
When it comes to working capital it never pays for businesses to be in the dark. Getting on top of your finances, and cultivating a healthy liquid assets balance is the defining difference between businesses that survive long-term and those that succumb to debt and administration.