Working capital: two simple words. But what exactly do they mean? If your understanding of this finance concept could do with a refresher, you’re not alone! That’s why we’ve put together this quick guide to get you up to speed on this important part of your business.
Working capital in a nutshell
Simply put, working capital is the difference between your current assets and current liabilities. But how does this look in practice?
Current assets are what your business can turn into cash in the next 12 months. Current liabilities are the expenses your business incurs in that same period. You’ll find both on your balance sheet.
Your current assets can include accounts receivable, cash and cash equivalents, inventory, prepaid expenses, shares and other assets that can be quickly sold. Jump to the opposite side of the ledger where current liabilities include: accounts payable together with any owed interest, wages, GST and company tax.
Calculating your working capital
Use this simple formula to calculate your working capital, sometimes called the net working capital formula:
Current assets – current liabilities = working capital
Your answer to this equation will show whether your business has sufficient short-term assets to cover day-to-day operations and short-term debt. A number greater than 0 is called positive working capital.
Want a quick snapshot of your business’s financial health?
The working capital ratio will give you exactly this. Essentially, it’s current assets divided by current liabilities.
So how should your working capital ratio look?
As a general rule of thumb, your business should have a ratio of at least 1. This means you can cover your short-term liabilities. Any ratio greater than 1 means you are in positive territory. You have enough cash to both cover expenses and reinvest back into the business.
What ratio should I aim for?
No two businesses are identical. Yet a basic ideal ratio is between 1.5 and 2.0. Where your business falls in this range depends on your type of business. When your ratio is too high, this indicates that your business isn’t taking advantage of its surplus assets and cash. Consider investing these into growing your business and proactively look for opportunities for diversification, innovation and growth.
Working capital management: no one size fits all
No cookie-cutter models apply to managing your business finances. This is because each business is unique. The optimal ratio for your specific business will depend on factors like your industry, goals and how long it takes to convert your products or services to cash.
Large businesses operate more easily with negative working capital because they can raise funds quickly when needed.
If your business holds inventory or manufactures products, your capital position may be more challenging. Lags can creep into your cash conversion cycle. This term relates to the time between spending money to purchase or create products/services and getting paid for these.
Service-based businesses usually have fewer challenges in this area. That’s because you usually don’t spend as much to deliver your service. On the other hand, if you’re a consultant or graphic designer, you’ll have expenses connected to service delivery. Yet not on the same scale as a business that must purchase manufacturing inputs or inventory.
Do you have a seasonal business? You’ll have higher needs during some periods. Say you’re a retailer. Your highest sales months will be those preceding Christmas. So you’ll have to stock up during slower times, which creates challenges.
Late invoice payments also negatively impact your financial situation. Keep a close watch on your receivables and swiftly follow up on overdue invoices to manage such impacts.
Overcome business finance challenges
If you crunch the numbers and come up short, don’t despair. Business working capital loans give you a vital gap-bridging solution. Working capital loans can bolster your business through low cash flow periods, help set you up to maximise high returns periods and grow your business sustainably.
Considering finance options? Look to Lumi.
Lumi is on a mission: to help your business access the funds it needs while protecting your cashflow and assets. We make this happen by offering several forms of working capital finance, including business loans and business lines of credit.
