When the current liabilities exceed the current assets, it is known as negative working capital. NWC becomes negative because the company lacks the required amount of funds/ cash/ short-term liquidity to fund its daily/ short-term expenses (within 1 year). However, dipping into negative working capital may not always be a risky move for a business, depending on the type of business category. It can also happen if a company makes a large purchase,
GETTING STARTED
What is working capital, and why is it important to your business?
5 min. read
Dec 18, 2023
Running a business is more than just the products. If you are a business owner, you have to handle a lot of things. Managing your business's finances, cash flow and working capital is extremely important to ensure solid financial health for your company. Establishing a business and making it successful without a sound economic structure and vision is not possible.
As a small business owner, you need to have a strong handle on your working capital and your cash flow. Cash flow is what your business generates or consumes while working capital refers to the difference between your company’s current assets and liabilities.
Knowing about current assets and liabilities is a must to run a business. Current assets are the properties and assets you have in the bank or those you can liquidate easily and convert to cash. Whereas current liability is what you have to pay for loans, salaries, debts, etc.
This article discusses the nitty-gritty of working capital , why it is important to maintain positive working capital, how to calculate it, what metrics you need to measure, and more.
As a small business owner, you need to have a strong handle on your working capital and your cash flow. Cash flow is what your business generates or consumes while working capital refers to the difference between your company’s current assets and liabilities.
Knowing about current assets and liabilities is a must to run a business. Current assets are the properties and assets you have in the bank or those you can liquidate easily and convert to cash. Whereas current liability is what you have to pay for loans, salaries, debts, etc.
This article discusses the nitty-gritty of working capital , why it is important to maintain positive working capital, how to calculate it, what metrics you need to measure, and more.
What is working capital and why is it important?
A healthy working capital plays a massive role in stabilizing a business. It is what helps your company to run on a day-to-day basis. It is used to fund daily operations and pay for short-term expenses and obligations like rent, taxes, interest payments, salaries and so on. In addition to daily operations, having a healthy working capital can help you fund business growth without incurring additional debt or even make it easier for you to raise funding, if you need to.
Here is why working capital management is vital to a business:
Here is why working capital management is vital to a business:
- Daily investment: From daily investments to short-term expenses, working capital can be used to fund all your day-to-day operations- —routine payments, taxes & interests, operating fees, unexpected costs, etc.
- Emergency/ unexpected payment: If your business has an emergency like serious debt, loan repayment, or financial crisis, saved capital in the form of marketable securities, inventory, short-term investments, cash, etc., can help in backing up the company and avoiding a serious cash crunch.
- Smooth operations and managing revenue fluctuations: Many businesses operate on seasonal demand. When the season is over, sufficient working capital provides you with a safety net that can help keep the company functional.
- Emergency loan: If the company requires emergency loans, it can use its working capital instead of taking a loan. This way, the company doesn't have to pay a considerable interest to the bank or any other financial institution and can continue with the business. Positive working capital also signifies that your company is creditworthy and that makes it easier to get loans sanctioned.
How to calculate working capital?
Here is the formula to calculate working capital:
Working Capital = Current asset - current liabilities
Current assets include:
• Cash, including money in bank accounts and undeposited client checks
• Securities and money market funds
• Short-term investments to be sold in a year
• Receivables minus allowances for unpaid accounts
• One-year notes receivable, such as customer or supplier loans
• Others include income tax refunds, employee cash advances, and insurance claims
• Inventory of raw materials, WIP, and final goods
• Prepaid insurance premiums
• Prepay for future purchases
Current liabilities include:
• Accounts payable
• Notes due within a year
• Payroll- salaries & wages to be paid
• Taxes due
• Loan interest payable
• Loan principal payable in the year
• Additional accumulated expenses
• Customer prepayments for undeliverable products or services
Another metric you need to watch out for is the working capital ratio.This is calculated as current assets divided by current liabilities. If your working capital is less than 1, it signifies financial challenges. It means that your company is not generating enough cash that can cover your expenses in the year. If the ratio is between 1.2 to 2, then it is a sign of a healthy company. If this ratio is greater than 2, you will need to make more effective use of available assets and consider reinvesting them appropriately to fund your company’s growth or generate revenue.
Working Capital = Current asset - current liabilities
Current assets include:
• Cash, including money in bank accounts and undeposited client checks
• Securities and money market funds
• Short-term investments to be sold in a year
• Receivables minus allowances for unpaid accounts
• One-year notes receivable, such as customer or supplier loans
• Others include income tax refunds, employee cash advances, and insurance claims
• Inventory of raw materials, WIP, and final goods
• Prepaid insurance premiums
• Prepay for future purchases
Current liabilities include:
• Accounts payable
• Notes due within a year
• Payroll- salaries & wages to be paid
• Taxes due
• Loan interest payable
• Loan principal payable in the year
• Additional accumulated expenses
• Customer prepayments for undeliverable products or services
Another metric you need to watch out for is the working capital ratio.This is calculated as current assets divided by current liabilities. If your working capital is less than 1, it signifies financial challenges. It means that your company is not generating enough cash that can cover your expenses in the year. If the ratio is between 1.2 to 2, then it is a sign of a healthy company. If this ratio is greater than 2, you will need to make more effective use of available assets and consider reinvesting them appropriately to fund your company’s growth or generate revenue.
Businesses that don't need a large working capital
Companies with lower upfront expenses and a steady cash flow, usually don't need a lot of working capital. Such businesses are known as 'low working capital' or 'capital-light' businesses. Some common types of enterprises that don't require much initial funding are:
1. Subscription-based models:
These are recurring revenue-generating businesses needing less working capital. that rely on a subscription model, such as streaming services, SaaS companies, or membership-based websites.
2. Service-based businesses:
Service-based businesses like consultancies, web design firms, and freelancers typically have low startup costs and small inventory needs. In these businesses, cash flow is usually maintained by the practice of billing customers for services rendered.
3. Dropshipping businesses
Businesses that rely on drop shipping do not keep inventory. Instead, they only make purchases from vendors when they have confirmed customer orders. This model reduces the need for higher working capital.
4. Online marketplaces or e-commerce businesses:
Several different types of companies are now running online marketplaces where they don't keep a lot of inventory, but generate revenue from connecting buyers and sellers. Such businesses need very little working capital.
On the other hand, running an online/ e-commerce business can also be relatively light on working capital as you wouldn’t need a large, consumer facing physical establishment. In case you want to create your own website in order to start selling online, consider SmartBiz by Amazon – an easy-to-use, mobile friendly website builder that can help you create your own website within minutes- without any design or coding skills. What’s more, you can try it out completely for free until March’2024 as part of our early access form. Interested? Contact us here.
On the other hand, running an online/ e-commerce business can also be relatively light on working capital as you wouldn’t need a large, consumer facing physical establishment. In case you want to create your own website in order to start selling online, consider SmartBiz by Amazon – an easy-to-use, mobile friendly website builder that can help you create your own website within minutes- without any design or coding skills. What’s more, you can try it out completely for free until March’2024 as part of our early access form. Interested? Contact us here.
Summary:
Every business needs to focus on efficiently maintaining its working capital. This will ensure having not only the right level of liquidity to fund its daily operations and expenses but also invest carefully to drive further business growth. It is absolutely critical to ensure smooth flow of operations. So, how do you plan to manage you working capital?
FAQ's
1. What is negative working capital (NWC)?
2. Are fixed assets considered part of working capital?
No, working capital consists of assets that can be liquefied easily. Fixed assets like real estate, equipment, as well as intangible assets like patent and trademarks are not a part of your working capital, but a part of your fixed capital.
3. Does working capital change?
For most companies, working capital keeps changing constantly on the basis of payments received/ due, seasonal sales spikes, returns on investments, inventory available etc.
4. What is a working capital loan?
A working capital loan is usually a short-term loan (6 months – 2 years) that can be availed by small businesses to fund the daily expenses and operations of a business. It can’t be used to fund business growth or asset expansion but only to meet short-term operational requirements. Depending on your business category, financial health and size, and size of the loan, the same can be secured against collateral or can even be unsecured.
COMPANY
Built in
© 2023 Amazon.com, Inc. or its affiliates. All rights reserved