What is working capital?

Working capital is a measure of the financial health of a business, expressed as a ratio. It is calculated by dividing the current assets by the current liabilities and is used to assess if a business has enough cash on hand to carry out it’s day to day operations.

The quickest way to get a health check-up of your business is to measure your working capital. It is the heartbeat of any organisation and it can tell you a few important things. It will let you know if you have enough funds to take advantages of opportunities as they arise, whether you’ve got too much tied up in cash and stocks or whether you’re in serious risk of going under.

In an ideal world, you’d buy something, make something or provide a service and get paid for it the next day. In this real world in which we live, that’s not the case. Businesses usually have to wait for many weeks to see a return on an outlay. Working capital is what is required to cover this gap and carry on trading as normal.

Calculating working capital

To calculate working capital you need to understand what the assets and liabilities of a business are. Assets are things that can be converted into cash within a year, whilst liabilities are things that are going to come due in the next 12 months.

AssetsLiabilities
Bank accountsAccounts payable
Stocks & bondsPayroll
Accounts receivableTax
InventoryDividends
PropertyOverheads
Raw materialsDebts (short and long term)

After dividing the assets by the liabilities you’re left with a ratio which represents net working capital. A positive number indicates that the company has sufficient capital to meet its operating requirements and make short term investments, whereas a negative figure indicates that they have a shortfall.

1.2 - 2 is ideal. If it’s over 2 then they may too much cash or stock on hand and are not making the best investment decisions.

Anything under 1 means that the business needs to take action to improve the situation. They may need to borrow additional funds. Negative working capital could prevent them from investing in growth initiatives, such as purchasing stock during a busy season or pursuing an acquisition opportunity.

In addition to the standard working capital formula, there is also the quick ratio. This is current assets, minus inventory divided by current liabilities. The reason stock is excluded is that in an emergency it cannot always be turned into quick cash.

Managing your Working Capital

It’s a balancing act between holding too much and too little short-term capital. The objective of working capital management is to achieve the right balance of cash flow through the business by:

AssetsLiabilities
Maintaining an appropriate level of cash or financing facilities, i.e. managing liquidityMaximising accounts payable terms
Minimising the levels of inventory on handMaintaining appropriate short-term borrowings and financing facilities to meet cash commitments
Minimising outstanding accounts receivables

Management processes

In order to properly manage working capital, a number of management processes must work together:

  • Accurate and timely measurement and reporting of the key variables which affect the overall level of working capital
  • A cash management strategy (eg management of cash and financing facilities to provide cash as and when needed)
  • Strategies to manage accounts receivable and accounts payables
  • Inventory management systems to ensure an appropriate level of inventory is held to meet demand, without over-investment

The combination of these processes should ensure capital is available to allow a business to meet its commitments with the flexibility needed to take advantage of opportunities as they arise, and without over-investing in unproductive assets.

Outstanding debts (receivables) owed has a direct impact on the working capital and is therefore critical for companies to ensure the collection process is well functioned to avoid a long payment receivables period.

Similarly, inventory levels need to be kept at the optimum level to positively impact on the working capital. Too much stock leaves a company vulnerable with no cash being received for the goods.

Creditors (payables) also influence the working capital as the longer it takes vendors to be paid, the longer the company maintains its working capital used for expenditure. The period between payment to the supplier and receipt of customer funds is called the cash conversion cycle (CCC).

Cash Conversion Cycle

The cash conversion cycle is a quick way to understand how quickly you can expect to see a return on your investments. How long it will take for the money you’ve spent to come back into the business.

You need to first understand three important numbers.

  • Inventory days - how long stock is sitting on a shelf. Or how long you’ve spent making something.
  • Debtor days - how long it takes you to get paid. It’s in the interest of any business to minimise this as much as possible.
  • Creditor days - how long it takes you to pay your invoices. Conversely, it’s in the interest of the business to maximise this.

Then you add the inventory and debtor days and subtract the creditor days. So the equation is:

(I + D) - C = CCC

For example, a wholesaler selling cleaning supplies purchases stock from a manufacturer. It takes them 65 days on average to sell those products and another 30 days to be paid, giving a total of 95 days. However the invoice for the stock they bought is only due after 45 days. This gives a CCC of 60 days. It takes 60 days to turn an outlay into cash.

(65 + 30) - 45 = 60.

It’s clear from this equation why effective management of accounts payable and accounts receivables is so important.

Coping with seasonality

Seasonal businesses, such a wholesaler of Christmas decorations or a gardening business may need a higher level of working capital. They'll need to support themselves through the entire year and may well have to purchase stock well before their busy season.

Sources of working capital financing

There are various sources of funding available to companies looking to manage their ongoing cash flow. These include:

  • Credit cards and overdrafts
  • Bank loan (although long term debt is rarely a good idea for day to day expenses)
  • Cash flow lending, including accounts receivable financing

The Waddle Difference

Waddle offers a modern form of receivables finance. We've built an innovative invoice finance solution allowing businesses to close the cash flow gaps that are holding them back. The Waddle platform seamlessly connects with cloud accountancy platforms, like Xero & MYOB and generates a finance offer within a few clicks.

Once approved, Waddle offers an instant line of credit based on your unpaid invoices, which is adjusted in real-time as they are raised and paid. You pick the invoices to fund and only pay for those that you draw down. And thanks to the cloud accounting integration, bookkeeping is a breeze with no invoices to upload and instant reconciliation.

It’s also fully confidential, so your important client relationships stay with you. And Waddle offers the friendliest terms with no minimum monthly spend, no contracts or hidden fees, giving you fast and easy access to working capital and a healthier balance sheet with minimal fuss. Get an offer now!