If you plan to start a business, you are probably learning a lot about markets, laws and other aspects of successful business ownership. However, you may not have considered the importance of working capital or know how much working capital you need to keep your company well-funded. These are things you should know about this tool.
Working capital is calculated by subtracting current liabilities from current assets. These liabilities and assets are short-term. Current assets include anything that can be quickly converted into cash. For example, inventory, marketable securities and accounts receivable are all considered current assets because it will take no more than one year to convert them into cash. Current liabilities include accrued expenses, short-term loan payments and any payable accounts you have that are due within one year.
Why It’s Important
This form of capital is the amount of assets, or money, you have left after you pay your obligations. It determines your company’s liquidity. Therefore, it is a vital tool used to perform a financial analysis of your business. This is especially important to lenders who may provide you with loans or those who may be interested in investing in your organization. However, your capital also helps you manage your cash flow.
What it Means
If your capital is negative, you are probably not using your assets to their fullest potential. This may be due to a lack of efficiency or mismanagement. However, continued negative capital can result in a liquidity crisis for your company. You may think that your investments in fixed assets will cover you, but when you have liabilities due, these assets cannot be easily turned into cash so you can pay your bills. Your lack of available cash can lead to late payments, poor credit reporting or additional borrowing.
However, negative working capital is acceptable in industries that can quickly make more money, such as grocery stores and fast-food franchises. These companies have high inventory turnover rates and abundant inventories. They also receive immediate payment from their customers. These types of organizations do not have to hold significant current assets.
When your capital is positive, your company has a healthy short-term financial analysis. You have enough liquid assets available to pay your short-term debts and other liabilities and you have money left over to fund your company’s growth. However, an abundance of capital also suggests that you are not using your assets efficiently.
Your ability to manage your working capital will determine the success of your company. Adequate capital gives your lenders and investors confidence that your company is operating efficiently and utilizing its assets properly.