Working capital is money you have to run the day-to-day expenses of your business, such as paying rent, buying/renting equipment, or paying salaries. This is not the same as operating capital which is about running your business effectively by using saved up money in a smart and helpful way.
Basically, working capital is like the money you have in your wallet to get a train ticket when going to school, while operating capital is the money in your bank account that you are planning to buy a car with.
Working capital is used to fund basic operations and also meet “right now” needs. It should also be able to fund the employees and suppliers and manage the business even when there’s a lag in business activities.
Positive working capital VS Negative working capital
Positive working capital is a good sign for your business. It means you have enough money and resources to cover your immediate expenses and debts without financial difficulties.
Positive working capital helps you handle day-to-day operations smoothly and allows you to invest in your company's growth and expansion. Moreover, it enhances your credibility with lenders, making it easier to secure loans when needed.
On the other hand, negative working capital can be concerning. It indicates that your business may need external help to meet its short-term obligations, like paying suppliers or creditors. This situation could lead to cash flow problems, difficulty managing daily operations, and even the risk of a business closure.
To avoid such issues, it's crucial to carefully monitor and manage your working capital, ensuring that you have enough cash and sellable assets to cover your immediate financial needs.
Best use of Working Capital
Working capital is basically a safety net for your business in rough circumstances, It's like having an umbrella when the weather changes suddenly. With enough working capital, a company can do extra things like get more supplies than the regular amount during high sales periods or doing the basic things like pay employees during a low sales period.
Types of Working Capital
There are different types of working capital that you must understand to run your company smoothly.
- Permanent working capital: This is the money readily available that a company must always have on hand to operate its business smoothly without interruptions.
- Regular working capital: This is a part of the permanent working capital and represents the money required for your company's everyday operations and activities.
- Reserve working capital: this refers to the money set aside for emergencies, seasonal changes, or unexpected events. It acts as a safety net to help your business handle unforeseen situations.
- Fluctuating working capital: this is the amount of money that is influenced by the company’s debt, so it's not a fixed amount. The amount can get bigger or smaller, depending on how much was borrowed or the collateral that was used to borrow.
- Gross working capital: this is the total amount of cash and assets a business has before getting any short-term loans or financing. It's the money available to meet immediate needs without borrowing.
Factors affecting Working Capital
There are two factors affecting working capital, which include
- Endogenous/Internal factors: company size, company structure, Company income and company strategy.
- Exogenous/External factors: thare things like banking services, business niche, goods and services offered, and the strategy of the company's competitor
How to calculate Your Working Capital
Working capital is calculated by subtracting a company's debts from what it currently has. It's the difference between what a business owns (current assets) and what it owes (current liabilities). This metric shows how much readily available money a company has to handle its short-term financial commitments.
For example, suppose a company has assets like cash, inventories, raw materials, and accounts receivable worth $350,000. In that case, it also has liabilities like wages, utilities, tax, loans, expenses, and owed salaries $200,000.
Working capital = $350,000- $250,000, given the company $100,000 as its working capital.
While calculating your working capital, only calculate your fixed assets like real estate facilities, equipment, trademark or patents that cannot be easily converted into cash.
How to manage your Working Capital
Managing your working capital well is essential if you want your company to run smoothly. Working capital management requires some financial strategy that involves using your working capital to meet your day-to-day expenses while ensuring that your company productively invests its resources.
There are several strategies to manage your working capital effectively. They include:
- Cash flow: The best way to take care of your working capital is by watching how money comes in and goes out. Making your money flow better is really helpful.
Think of it like water in a river. If the water flows smoothly, everything works well. If it gets stuck or takes a long time to move, it can cause problems. So, when you make things move faster, like getting money in quicker and paying out less slowly, it's like making the water flow well in the river. This helps your working capital stay healthy and strong.
Creating a budget and running an analysis of the money that goes in and comes out is an easy way to track your cash record.
- Inventory management: Inventory management is also a strategy for managing working capital. Inventory are the things in the company’s stock that can be easily sold.
Having too many things in stock can cost a lot because you need to keep them safe and they might go bad. But having too few things is also a problem. You might lose customers and miss out on sales. Finding a good balance helps you keep your working capital healthy.
- Negotiating payment terms: Negotiating favorable payment terms with your suppliers is a helpful way to manage your cash flow.
You can get more extended payment periods, discounts on early payments, or flexible delivery schedules. This will reduce how much you pay out, extend how long you can keep cash in the business’s account, and lower financing costs, and improve your working capital.
- Short-term financing: Getting short-term financing loans can help boost your business when needed. You can use the extra cash to run things smoothly without having to owe suppliers or employees.
You can use these loans for various purposes like buying more inventory, equipment, business expansion, payroll, and business management. Just be cautious not to borrow too much short-term financing. Only take what you can comfortably repay within the agreed timeframe to protect your working capital.
Working Capital management cannot be achieved without enough capital. You must first have enough cash available to cover both planned and unplanned expenses while using available resources for growth. Working Capital is a crucial part of your business finance system.
Understanding and implementing working-class strategies will boost your finances effectively and set your business on its path to success.