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Working capital is one of those terms that people use a lot; they’re familiar with the basic concept and definition but real life application of the term is often confusing and hard to understand. Working capital is a fundamental part of every kind of business, from small retail stores to large multi-million dollar companies. Therefore a comprehensive understanding of what working capital means and how it affects all aspects of business is essential to both the growth and success of any company. Here’s our introduction to working capital.
What is working capital and why is it important?
Working capital is the total amount of money (liquid assets) a company has access to for daily tasks and operations. This usually includes cash, money for planned expenses such as employee salary, inventory and money for unplanned expenses.
Working capital is also used to measure a business’s general health, is it successful? Or is it having trouble? Banks and lenders will often look at a company’s working capital when processing a loan application, if a company has negative working capital they are less likely to be approved for a business loan.
Positive and Negative Working Capital
When a company has positive working capital it means that it has enough liquid assets to cover or pay off its short term liabilities, this means any debts or bills that need to be paid soon. If a company can’t pay its bills, that are due in the near future, because its spending and debt outweighs the money available to pay the bills then the company has negative working capital.
What’s the difference between working capital and cash flow?
Working capital and cash flow are often confused as they both deal with the cash that a company has at any given moment. Cash flow is the money that a company makes in a certain amount of time; it is affected by outside variables and differs from month to month. While working capital is used to assess the overall health of the company in the present. Working capital is the liquid assets or cash that is available in the present to pay off any liabilities or bills, should they need to be paid. Not the amount of money that is being brought into the company.
How to Calculate Your Working Capital
Understanding what working capital is and how it differs from other financial and business terms is the most difficult part of the process. The calculation to figure out what your company’s working capital is actually quite simple. You’ll need to know the total amount of assets and liabilities that your company currently has, these numbers should be easy to find as they will be listed on your company’s balance sheet. Once you have both of the numbers all you have to do is subtract liabilities from assets and the number you’re left with is your working capital.
For example, if your company’s total assets are $50,000 and your total liabilities are $20,000 then your working capital is $30,000.
How much working capital does a company need?
There is no exact amount of working capital that every single company needs, it completely depends on the type of business, products and services the company has and is involved in. Obviously the higher your business’s day to day expenses are the more working capital you’ll need. As a rule of thumb you should consider how much money you’ll need to cover unexpected orders, seasonal orders, new equipment and all other regular expenses that your business has.
Every company is different so it’s up to you (or your accountant) to determine and keep track of how much working capital is required to maintain your business. Your company probably has an operating cycle, you’ll use this period of time to calculate how much working capital you need. Let’s say your operating cycle is one month, work out what your accounts receivable, inventory and accounts payable are for one month. Then answer these questions:
- How many days does it usually take you to collect the money you’re owed (receivables)?
- How long does your inventory usually last?
- How long does it take you to pay what you owe (payables)?
The average company has trouble supporting one operating cycle solely on their receivables. So based on the questions you’ve answered you should be able to determine what the shortfall is between what you make (receivables) and what you spend (payables and inventory). This shortfall is the amount of working capital your company needs to run.
How to Get More Working Capital
Lots of companies need to borrow money to have enough working capital to perform day to day tasks and there are many different types of financing available to business owners from many different sources. Generally speaking a business usually needs either a long term solution or a short term solutions to their working capital issues.
Long-term working capital solutions:
- Net income that is generated by the company itself.
- Long-term loans from banks or private lenders.
- Selling capital assets.
- Investor funds or equity funding.
Short-term working capital solutions:
- A line of credit (that will be paid back once receivables are collected).
- Accounts receivable financing (you’ll sell your accounts receivable to a third party and they’ll handle the rest).
- Equipment financing (for the purchasing of new equipment).
- Merchant cash advances.
Having a large amount of cash to run a successful company is difficult, borrowing money to cover working capital is something that almost all business owners must do at least once. Working capital is the insurance your company needs so that you can fulfill your orders and cover all your expenses. Even if you’re running a business that makes a lot of money, if your company doesn’t have enough working capital to function on a day to day basis it won’t be successful in the long run. This is why it’s very important that you, as a business owner, understand what working capital is and ensure that your company has enough of it.
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