What is working capital and why do you need it?

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You probably already know productivity and profitability in your Profit and Loss Statement is really important. But your business finance is in no way limited to that. There are many figures to keep an eye on, and working capital is essential for your business’s health and growth.

Why is working capital important?

Positive working capital is the operational lifeblood of a firm. It is what you need to give you the grunt to scale and grow your small business. It is the thing that will protect you and keep you safe through the highs and lows of business. In other words, it is your best friend in business and if you’re wondering where to find it, it lives in your Balance Sheet.

That’s great, I can hear you say. But what is it, you ask?

What exactly is working capital?

Working capital, in simple terms, is the cash available for the day-to-day operations of a business.  Or, in more technical terms, the working capital formula is equal to your current assets, less your current liabilities. Whatever is leftover is what you are working with. 

Because working capital is your on-hand cash and cash equivalents, your short-term debts and your operating expenses combined, you can, in fact, have a negative working capital balance. This you should try to avoid at all cost. 

The accumulation of working capital in your Balance Sheet comes from ensuring the security of revenue. This is achieved through the completion of engagement documentation during client onboarding. It reflexes strong credit control, due diligence, invoicing, cash flow management and debt collection practices. 

Five factors come in play: Collection period, credit period, current ratio, cash conversion cycle and stock turnover. Your system of dealing with those, constitutes a working capital management framework. Positive capital is the testament of good business practices.

Why is it important to have a working capital framework?

A strong framework and good systems in your business equals adequate and stable working capital. Having that capital means you can weather the inconsistency of client payments. It additionally provides you with the extra cash you need when you are growing and expanding. 

With working capital, you become open to the possibility of answering to new contracts and widening your clientele. It helps you cover the cost of raw material, for example, to deliver on those contracts. 

It also allows you to extend payment time frames to loyal clients who have just hit a rough patch. Losing clients altogether is a bad move. Having finance options allows you to make a choice, once you assess the credit risk and short term liabilities.

In simple terms, the best framework you have, the highest resilience and financial options are at your disposition.  It gives you flexibility and the capability to deal with short term setbacks. 

The measure of a company’s potential for growth often lies in that working capital, and how much of it can be injected back into the business.

How to figure out your working Capital Ratios?

So how do know what your level of working capital is?  A good way to assess it, is to look at your solvency ratio or current asset ratio calculated from your Balance Sheet. It is as simple as that. And now you can start planing in accordance. Do you need to rethink your framework? Or is it time to boost your business for growth?

Are there other ratios to assess your business’s health?

The short answer is yes. 

Seven other ratios can be calculated from both your Balance Sheet and your Profit and Loss Statement. Amongst them, the most used are the common size ratios, liquidity ratios, efficiency ratios, and solvency ratios. Those give you a strong indication as to whether your business has the working capital it needs and is in a strong growth-oriented state.

Should you be interested in how your business and working capital shapes up right now, we have developed a business review of financial and non-financial data for companies interested in better structuring their growth or businesses in financial distress.  Please email or call Climb Business if you would like to chat about working capital management within your company.

We are focused on and are committed to our client’s business success.  Our expert business advice is delivered with optimism and encouragement.

Get the assistance you need to assess your prospects and plan accordingly.

We specialise in helping directors of small businesses in financial distress and have your best interests at heart. 

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