Understanding Working Capital: What Every Business Owner Should Know
Businesses require two important financial metrics: working capital and cash flow to ensure the smooth operation of their organisation. These metrics help businesses analyse whether they can navigate through an economic downturn. Most businesses preserve their profits to cover long-term liabilities or expenses. But what about short-term expenses? This is where you need working capital.
Imagine you are unable to pay bills or purchase inventories on time, operations could grind to a halt. This is where working capital comes handy.
In this blog, we will understand one of the essential parts of financial management, which is working capital.
What is Working Capital?
Working capital is the difference between a company’s current assets (including cash-in-hand, accounts receivable, raw materials and inventory) and current liabilities (including accounts payable, taxes, wages, salaries, and unearned revenue).
Working capital is an inevitable part of financial management. It helps businesses manage cash and cash equivalents to meet short-term financial goals (within 12 months). In other words, it represents a company’s capability to generate cash instantly and effectively manage its day-to-day operations.
When current assets are more than current liabilities it indicates positive working capital. This means the company can meet daily operations and invest in growth opportunities. On the contrary, negative working capital denotes low liquidity and difficulty in paying debts.
Now, the next question arises: how do you calculate working capital?
How to Calculate Working Capital?
Working capital, also known as net working capital is the amount of money readily available for daily expenses and short-term financial goals. To calculate working capital, you can use the following formula:
Net Working Capital = Current assets / Current liabilities or Net Working Capital = Current assets – Current liabilities.
Example – A company holds current assets costing $2,00,000 and current liabilities as $1,00,000. Here, the working capital ratio will be 2:1. Hence, this is a healthy ratio with enough liquidity over debts.
Similarly, if a company has current assets totalling $150,000 and current liabilities amounting to $90,000, the working capital would be:
Working Capital=150,000−90,000=60,000
This means the company has $60,000 available to cover its short-term obligations and invest in operations. However, it’s important to note that the amount of working capital companies require may depend on various factors, including the nature of the business, market condition and operating cycle.
Why is Working Capital Important?
By far, we have covered what is working capital and working capital computation. Now, let’s unravel the significance of working capital management in a company.
Liquidity: Sufficient working capital indicates that a company has sufficient current assets to meet its short-term financial goals.
Operational Efficiency: An efficient working capital management streamlines an organisation’s operations. This includes timely payments to suppliers and employees, maintaining resources, reducing waste, and boosting productivity.
Cost Reduction: By minimising debts and inventory costs, businesses can increase their profit and return on investment (ROI).
Creditworthiness: Adequate working capital determines creditworthiness to lenders and investors. When there is a positive working capital, it makes it easier for organisations to get their loans sanctioned for future investments.
- Growth Opportunities: Sufficient working capital allows businesses to invest in strategic initiatives without relying on external finances. It also helps in funding financial resources like launching a new product, entering a new market or scaling operations.
Risk management: By maintaining an adequate level of working capital, businesses can mitigate risks associated with cash shortages. Companies with strong working capital positions can respond quickly to changes in the market without needing to secure additional financing.
Tips to Manage Working Capital Effectively
With the challenging economic landscape, businesses should learn to prioritise financial management for operational efficiency. Here are some helpful tips for efficient working capital management:
- Monitor Inventory Level: Regularly review inventory levels to ensure they align with sales forecasts, which can free up cash tied in unsold goods. Excess inventory increases storage costs and maintenance expenditures.
Build Strong Relationships with Suppliers: Maintaining good relationships with suppliers works great for your business in the long run. Businesses get the opportunity to get bulk discounts and early payment concessions.
Manage Payment Policy: Establish clear payment terms and an efficient cash collection policy. Incentivise early payments and impose penalties for delays to ensure steady cash inflow.
- Analyse Financial Performance: Businesses should formulate working capital computation to understand the historical performance of a company. Along with this, it helps in identifying trends, opportunities and risks.
Monitor and Control Costs: Regularly review operational expenses to identify areas where costs can be cut without affecting quality. Implementing disciplined spending practices can help maintain a healthy working capital balance.
Types of Funds for Working Capital Management
Financing of working capital defines various ways businesses can obtain the required funds to finance their daily operations and meet short-term goals. Here is an overview of some common types:
Invoice Financing:
This financial solution allows businesses to borrow money against their outstanding invoices. It is a good option for businesses that have a lot of cash tied up with their clients. Instead of waiting for weeks and months for their clients to pay them, these businesses can reach out to invoice financing companies. These financial institutions can sanction their payment in the next 48 hours or less.
Business Loan:
With short-term loan options, companies can improve their cash flow and make strategic investment decisions. These commercial loans can be used for various purposes, including purchasing inventory, financing expansion projects, or managing day-to-day expenses. They provide flexibility in how businesses can use the funds to strengthen their operations.
Asset Refinancing:
It allows businesses to use existing assets, such as equipment or property, to secure funding. These assets act as collateral, enabling businesses to obtain loans or lines of credit that provide essential capital. This type of financing is particularly beneficial for companies looking to improve cash flow while retaining ownership of their assets.
Trade Finance:
Trade finance is important for businesses involved in international trade. It helps manage the financial risks associated with cross-border transactions by providing guarantees and financing options. Trade finance solutions include letters of credit, trade credit insurance, and various financing arrangements that ensure smooth and secure trade operations.
Choose MC Finance for Your Working Capital Financing!
With our expertise and experience, we help businesses achieve the perfect balance in managing liquidity and operational efficiency. Here are the reasons you should choose us:
Experience: Our team has a deep understanding of the complexities of business finance. They offer expert guidance to help you navigate the financing process effectively.
Personalisation: Exploring different financing options for working capital can be a game changer. We understand that every business is different and so are the financial needs of each business. We thoroughly comprehend your business goals and formulate personalised strategies to address your unique circumstances.
- Quick and Easy Process: Our application process is easy, fast and hassle-free. We streamline required documentation and eliminate unnecessary complexities.
Affordable Prices: We offer our services at a fair and reasonable price to our clients.
Flexible Repayment Options: We formulate fixed repayment terms to align with the financial management of a company. This structure is made to determine the repayment structure that suits cash flow needs.
Client Support: We provide support and guidance to our clients throughout the funding process. We offer a range of financial solutions to maximise your company’s cash flow and use your working capital efficiently.
We, at MC Finance Group understand the challenges of managing working capital. Our commitment to delivering effective financial solutions makes us a trusted partner for businesses. Do you want to take your business to the next level? Let’s talk about how our services can help – call us on 0430 200 322 or email us at Matthew.chik@mcfinancegroup.com.au.
FAQs
If the ratio is too high (higher than 2.0) then it could mean that the business isn’t making enough to accumulate adequate cash and cash equivalents to invest in expanding business.
