Two small business owners walked into a bar. They discussed working capital. This is not a joke. Working capital is no laughing matter. It is more than just a buzzword. Here is everything you need to understand about working capital for small businesses.
What is Working Capital?
To put it simply, working capital is the money a business uses for its day-to-day operations. It is the amount of money held up in operations.
In accounting terms, working capital is calculated as current assets (things you own that can be converted into cash) – (minus) current liabilities (costs you will incur in the next 12 months).
Calculating working capital helps determine the financial health of the company. It means the business has more assets than liabilities and can easily cover its liabilities.
Here are some examples of items that fall under current liabilities:
- Salaries payable
- Monthly/quarterly bills (covers utility)
And here are some examples of current assets:
- Stocks or Bonds
Why is working capital important?
What happens when you run out of money to meet your day-to-day business needs? Bankruptcy! Having a negative working capital balance is bad because you don’t have the money to keep your business afloat and therefore, you may have to shut down.
Lenders are also skeptical of giving loans to businesses that have a poor working capital balance.
So, how much working capital does your small business need?
Working capital depends greatly on the nature of your business. If you are an online clothes or accessories retailer, you may need to maintain inventory at all times. If you’re a seasonal business, you may need to stock up at certain times of the year only.
Here’s how you can determine your working capital needs:
Calculating your working capital requires you to determine your operating cycle. Think of Operating Cycle as your money’s journey.
Here’s the perfect example from Brighthub:
“If a company purchase raw material on day 1, manufactures the product on day 7, and sells it on day 15, receiving payment on day 23, the working capital cycle is 23 days.
If the company sells the same product on cash basis, the working capital cycle is 15 days.”
While calculating working capital or its ratio (current assets/current liabilities), a ratio between 1 and 2 is considered good. Then again, an excess of working capital also indicates financial inefficiency.
Tips to manage working capital smartly:
Experts believe working capital management is probably the toughest accounting job for a business. That’s why we put together a few tips to help you manage your working capital, smartly:
- Plan your cash flow beforehand.
- Set realistic sales and profit goals.
- Figure out sources of short term loans for bad/rough times and use them only when in dire need.
- Record your expenses and keep track of your accounting.
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