Posted on January 30th, 2023.

The cash you have on hand—whether profit-savings, a financial institution loan, or different means of raising capital—is your working capital. Working capital funds your every day operations, helps you pay rent and staff, and covers different operational expenses.

Basically, working capital is the cash you have to take care of your temporary expenses. 

What Situations Require Working Capital ?

For your company to be able to pay its employees, pay its bills, maintain a healthy cash flow, and ultimately be stable, it needs to have a specific amount of working capital.

But there's a chance that you'll occasionally require more working capital. Calculating your working capital at this point becomes crucial. You might require extra operating capital, for instance:

to maintain your company's viability while cash flow is sluggish. Imagine you own a seasonal business, such as a lawn care service. If you reside in a northern environment, your busiest seasons will be spring and summer. You might need to hire additional employees or spend more money on equipment during that period. Moreover, during the off-season, when sales are weaker.

Working Capital Calculation Methods

Simple working capital calculation:

Current Assets - Current Liabilities = Working Capital

 Current ssets are cash and assets you can convert into cash within a year (this doesn’t include fixed assets, which are considered long-term assets on your balance sheet). Accounts receivable, inventories, and short-term investments are included in these assets.

Current liabilities are short-term liabilities (debts or accounts) that must be settled within a year, such as accounts payable, overdrafts, sales tax, payroll costs, and wages. Current liabilities also include accumulated expenses and accrued liabilities.

You should strive to have more current assets than liabilities or positive working capital to ensure good short-term financial health. If you have a deficit, you could experience cash flow issues, and you might not be able to make creditor payments if current assets do not exceed current liabilities.

Even a successful company may run into problems. When cash is locked up in assets like debtors or raw materials and cannot be converted back into cash, it indicates low liquidity.

How do you determine the appropriate amount, though, even after calculating your working capital? The working capital ratio is here.

WHAT THE WORKING CAPITAL RATIO MEANS

The ratio serves as a gauge for your company's financial stability. The equation is:

Current Liabilities / Current Assets = Working Capital Ratio

The ratio aids in determining whether you have enough working capital to pay off your debt and other short-term liabilities. Negative working capital is indicated by anything lower than 1. Anything above 2 points to a lack of investment in excess working capital and assets and an excessive amount of cash held in inventory, raw materials, or debtors by your company.

Typically, a ratio of between 1.2 and 2 suffices. A long-term declining ratio might be cause for concern and call for immediate action. For instance, it might suggest that your collection efforts are inefficient, which would be reflected in your accounts receivable.

How to Increase Working Capital (or Deal with Decreased Working Capital)

You must find the working capital you need to cover your costs if you don't already have it, or you run the risk of your project failing. Bank loans are an option, but the application process is lengthy and approval isn't always guaranteed.

The answer is to locate funding somewhere else. A business finance Broker such as, MCS Capital, has many funding solutions to help sole deficits in working capital .

Three Working Capital Red Flags

There are a number of lending practices and funding options that try to take advantage of a company's working capital issues that you should be aware of and steer clear of.

1. CHECK FOR SUSPICIOUS FEES

The advertised funding cost frequently differs from the actual cost. Many lenders tack on extra costs like inactivity and subscription fees. In order to avoid unexpected and frequently expensive fees, your accountant, giving them access to your balance sheet and other financial documents.

2. MAKE SURE NOT TO OVERSPEND ON FINANCING.

Many companies open up larger and larger lines of credit when they really only need a small amount. Speak with your accountant, give them access to your balance sheet and other financial documents, and get their expert opinion on the size of the line of credit you require and the credit terms that should be included.

3. AVOID PAYING NEW CUSTOMERS FROM OLD CUSTOMERS' REVENUE

Many small business owners use the money from a previous client to pay for the following one. If you do this frequently, cash flow issues could arise very quickly.

The takeaway is to always conduct thorough due diligence before borrowing money in order to avoid making poor choices out of desperation.

Important Lessons on Working Capital

Working capital is essential for running your daily operations, supporting business expansion, and supporting you in trying times.

Understanding it is crucial, so learn what it is, how to calculate it using the working capital formula, and where to find funding.

Your business needs will determine how you approach the situation. You might need to use invoice financing, request an upfront deposit, apply for a short- or long-term loan, or speed up the collection process.

Whatever you choose, you can relax knowing that you have the financial resources to expand during prosperous times and endure during difficult ones.