What Is Working Capital: The Definition & Why It Matters
What Is Working Capital: The Definition & Why It Matters
- What is working capital?
- Working capital vs. net working capital
- Why is working capital important?
- Challenges with limited working capital
- How to calculate working capital
- What are assets to consider in working capital?
- What are liabilities to consider in working capital?
- How to increase working capital
Every business knows that working capital is a vital element in operational longevity. Having a sufficient amount of it can make the difference to survival or failure—especially for Small and Mid-sized Businesses (SMBs). The U.S. Bureau of Labor Statistics (BLS) data estimates that a whopping 65% of businesses fail during the first 10 years, and only 25% of new businesses actually survive for 15 years or more. And that is under mostly ‘normal’ business conditions. Failure rates can be significantly higher during a global crisis such as the COVID-19 pandemic—impacting virtually every size of business across all sectors.
Numerous small businesses across various sectors entered the COVID-19 crisis with low levels of financial resilience, making survival extremely challenging. The cost of servicing debt for many of these for small manufacturers has been estimated to be a lofty 30% of revenue—11% higher than in sectors that are financially stronger such as, scientific or technical services. In the restaurant industry, almost 40% of smaller restaurant businesses operate at a loss—or just break even. Ultimately, this accelerates their need for SMBs to secure more affordable financing options.
For most sectors, the key to survival and thriving beyond the pandemic is having enough affordable working capital—which, in turn, also relies on excellent working capital management. It allows your business to take advantage of opportunities, smooth out the operational and financial bumps, and enable sustainable growth.
We’re shedding light on some of the top questions about working capital. Here, you’ll learn the essential things you need to know:
- What is working capital? (And is it the same as net working capital?)
- How to calculate working capital
- How to improve working capital
What is working capital
Working capital is the amount of available cash or liquid assets your business needs for day-to-day operational expenses. It's calculated using current assets minus current liabilities (defined as being due within 12 months). Working capital is the amount your company has readily available for day-to-day operations and paints a picture of your company's operational strength, efficiency, and overall financial health. However, excess working capital over a lengthy timeframe can indicate assets aren’t being managed effectively.
Is net working capital the same as working capital?
Working capital and net working capital both refer to the difference between current assets and current liabilities—but there’s a difference.
Net working capital is more narrowly defined and calculated as current assets (excluding cash) minus current liabilities (excluding debt). It excludes most types of assets to focus solely on Accounts Receivable (AR), Accounts Payable (AP), and inventory.
What is the importance of working capital for a company?
Even the strongest financially stable organizations need working capital at one point or another. Why? Because things are constantly changing, and there are often unforeseen risks, as we saw with the pandemic. If you further consider how long the pandemic has been around, it can have a monumental impact on any business, not just SMBs. Due to this or other factors, virtually all businesses need affordable working capital to address challenges. Without it, things are unlikely to improve, and a competitive edge can be lost.
Challenges with limited working capital
Any business that has struggled to maintain adequate working capital knows it can have far-reaching implications. In isolation, each of these challenges can be problematic—combined, they can lead to enormous repercussions.
- Late payments on expenses
- Struggling to maintain favorable terms and relationships with suppliers
- Not keeping up with changing customer expectations
- Not meeting payroll
- Losing out on opportunities as they arise
- Lagging behind on innovation
- Not being able to leverage needed technologies
Addressing these challenges rests on having a solid understanding of what your working capital situation is and finding ways to increase it. Let’s take a closer look at how to calculate your working capital.
How to Calculate Your Working Capital
The working capital calculation uses the current assets and current liabilities reported on your company’s balance sheet.
|Working capital = Current assets – Current liabilities|
The net working capital calculation is more specific and excludes cash and debts—it’s calculated as follows:
|Net working capital = accounts receivable + inventory - accounts payable|
What are assets to consider in working capital?
There are different types of current assets that can be included in working capital as long as they can be converted to cash within a 12-month time frame. These current assets can include cash and equivalents such as funds in bank accounts, including checking or savings accounts. It can also include high liquidity cash equivalents such as treasury bills or money-market funds—or other investments like stocks, mutual fund shares, and potentially bonds. Inventory and AR amounts owing that can be turned into cash in less than one year can also be counted.
What are liabilities to consider in working capital?
Current liabilities are short-term debt payments such as bank loan payments or commercial paper issued to finance things like payroll, accounts payable, and inventories. It can also include amounts owed for raw materials and business or technology services support.
Bank interest payments owed on short-term debt, current interest payments due for long-term debt, and income or payroll taxes owed can also be considered.
What is an example of working capital in a balance sheet?
Working capital example:
Let’s say your business produces paper cups, and on April 30, 2022, your balance sheet showed current assets of $1 million and current liabilities of $500 thousand. Your company’s working capital would have been calculated as $1 million - $500 thousand = $500 thousand in working capital.
Net working capital example:
Using the same example above but with an additional $250 thousand in inventory on hand that could be sold quickly. Your net working capital would have been calculated as ($1 million + $250 thousand) - $500 thousand = $750 thousand in working capital.
Change working capital – Why & how to increase working capital
Armed with the right information from your balance sheet, the working capital calculation, and the net working capital calculation, sorting out your working capital situation is easy. Now that you have a solid grasp of your company’s working capital, you’ll also want to calculate the change in working capital between periods. This ensures you know how your working capital management is performing. If you’re comparing it to last quarter, for instance, the calculation would look like this.
|Change in working capital = Current working capital - Last period’s working capital|
Here’s an example:
If your company has current assets of $500,000 and a current liability of $200,000 for 2022 and the current asset and current liabilities for 2021 were $400,000 and $10,000, respectively, the calculation would look like this.
2022 working capital = $300,000 ($500,000 in current assets - $200,000 in current liabilities)
2021 working capital = $390,000 ($400,000 in current assets - $10,000 in current liabilities)
The change in working capital would be ($90,000)
In this example, the change between 2022 and 2021 in working capital is negative and viewed by management as too low for business requirements, it could mean that your company would have to find ways to increase working capital.
Benefits of increasing working capital
While money doesn’t solve everything, increasing working capital can solve your company’s most troubling roadblocks, such as funding instability—leading to benefits such as these.
- Meeting current expenses while gaining through reduced cash outlays
- Maintaining favorable terms with suppliers and gaining pay-early perks
- Meeting or exceeding changing customer expectations and gaining their confidence
- Meeting payroll and reducing employee turnover
- Capitalizing on market opportunities as they arise
- Being able to fund innovation through new talent
- Leveraging powerful technologies needed to improve processes and productivity
- Gaining time needed to effectively analyze and measure business performance
Capitalizing on benefits is all about strategy. It’s important to also ensure that the benefits your business is looking for actually align with strategic goals. It’s essential to increase working capital in ways that don’t hinder payment acceptance flexibility. Not all working capital loans provide the flexibility that accommodates supplier and customer needs.
Ways to increase working capital
Increasing working capital is all about choices—something many companies around the globe lacked throughout the pandemic. And, it's not only your business choices but those of your suppliers and customers. It’s about the collective choices that ensure the long-term success of each of your business relationships—translating to growth opportunities for your suppliers, your customers, and ultimately your business. By increasing your working capital, your business can choose what to pay, how to pay, and when to pay.
One way to do this is to expand your payment options—and use them strategically. For example, a challenge most manufacturers face is that their landlord, taxing authority, and other vendors may not accept payment using a credit card; they may only accept cash, a wire transfer, ACH payment, or a working capital loan. Using a business credit card can create a float of 30-50 days or longer. This can help stretch working capital when it’s needed the most and deliver some powerful benefits discussed earlier.
The success of any business rests on removing barriers, especially financial limitations, and having more flexibility and choice. As we’ve seen during the pandemic, it can greatly increase your company's rate of survivability during a crisis. It can also improve business performance, open the door to partnerships and opportunities, help expand your customer base, and generate more revenue in ways that may not have previously been possible.
Find out how your business can increase its working capital and gain operational and financial excellence.