How does Working Capital work?

What is working capital?

Working capital is a crucial metric for any company's financial health. It determines a company's ability to pay its bills and keep operations running smoothly while at the same time investing in business growth. Maintaining sufficient working capital is crucial for any business to cover liabilities and fund growth without incurring debt. With enough working capital, a company can continue to pay employees, suppliers, and other obligations even during cash flow challenges.

How do you calculate working capital?

The balance sheet, as we’ve discussed in previous editions, provides us with a snapshot of the company's assets, liabilities, and shareholders' equity at a moment in time, such as the end of a quarter or fiscal year. It includes all a company's assets and liabilities, both short-term and long-term by categorizing assets and liabilities as current and non-current. To jog your memory on how a balance sheet works, check out this past newsletter on balance sheets. We extract information from here for our working capital calculation.

Working capital is the company's current assets less current liabilities, as listed on the balance sheet. Current assets include cash, accounts receivable, and inventory, while current liabilities include accounts payable, taxes, wages, and interest owed.?

Working capital as a tool to navigate uncertainty

Working capital is an essential tool for businesses to navigate fluctuations in revenue, especially if they experience seasonality in sales. By maintaining adequate working capital, companies can prepare for busy months by making extra purchases from suppliers while meeting their financial obligations during periods of lower revenue. For instance, a retailer that generates 70% of its revenue in November and December can ensure it has enough funds to stock up on supplies before the busy season begins and hire temps while planning how many permanent staff it can support. Analyzing working capital needs and maintaining a buffer is crucial for businesses to thrive in the long run.

What is working capital management?

Working capital management is a crucial financial strategy that can make or break a business. At its core, it's all about optimizing the use of working capital to meet day-to-day expenses while ensuring the company invests its resources in productive ways. ?

How to increase working capital

Here are some ways to increase working capital and ensure the business can navigate uncertain periods:

1. Take on long-term debt to increase current assets.

2. Refinance short-term debt as longer-term debt to reduce current liabilities.

3. Sell illiquid assets for cash to increase current assets.

4. Analyze and reduce expenses to reduce current liabilities.

5. Optimize inventory management to reduce overstocking and the likelihood of inventory write-offs.

6. Automate accounts receivable and payment monitoring to increase cash flow.

These tactics can help bridge the gap when you need to cover project-related expenses or experience a temporary drop in sales. By adding to current assets or reducing current liabilities, companies can increase working capital without overly burdening the company.

I hope this gives you a working knowledge of working capital.

Best,

Mark

www.accountingmadeeasy.co