Why is Working Capital Important for Business Success?
6 min. Read
Last Updated: 09/03/2015
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When it comes to financial performance, many business owners focus on the bottom line. So, making a profit the most important thing? Not so fast. There's another number to watch that could mean the difference between staying afloat and sinking fast. It's called working capital.
Why is working capital important? It represents the amount of cash available for you to operate while meeting your obligations. The accounting profession defines working capital as the difference between current assets and current liabilities. To understand that, let's define these terms.
Current assets include cash, inventory, and accounts receivable—property that is either cash now or can be turned into cash within one year. Of course, long-term assets—furniture, real estate, vehicles—can be sold and turned into cash, but they aren't regarded as "liquid" as current assets. Besides, if you sell off your business assets, you won't be able to operate the business.
Current liabilities include the bills and loan payments you must make within one year. If you have a long-term loan, say for equipment or real estate, you include only the portion you will need to pay within twelve months. The rest is filed under long-term liabilities.
The difference between current assets and current liabilities is your working capital. This should be a positive number. If negative, it shows a deficiency of working capital and means that you will likely run out of cash to run your business. While analyzing your financial statements, bankers and accountants calculate the current ratio, rather than being interested in the specific dollar value of working capital. They use the ratio as a quick way to determine your company's financial health.
To calculate the current ratio, divide current assets by current liabilities. A healthy company will have a current ratio of 1 or higher. The desirable ratio may also vary by industry, since some require more liquidity than others. The next step the banker will take is to evaluate the quality of those assets. For example, if some of the accounts receivable are old and unlikely to be repaid, they might be subtracted from the current asset balance.
Another area that will be scrutinized is inventory. If a great deal of it is dead and needs to be sold at a loss, that will be taken into account. So will how fast inventory moves, or "turns." There are standards for different types of companies and slow moving inventory ties up working capital. The amount invested in the inventory can't be used to make or buy more until the old inventory is sold.
Improving your working capital ratio is a complex proposition influenced by many factors. To improve cash flow, shorten the accounts receivable collection time. Trim accounts payable and save cash by taking advantage of discounts. In addition to declining sales, one of the main reasons companies experience a working capital shortage is they don't understand the ratio between sales and expenses. There isn't enough profit built in so adding sales merely racks up associated expenses. Understanding and calculating working capital is a good step in better managing your company finances.