Importance of Working Capital

May 10, 2022
Importance of Working Capital

When it comes to business success and financial health, money is a top priority. This is as true for startups looking to scale as it is for established companies looking to stay afloat. One form of money that is important for business owners is called working capital. 

Working capital can be used to purchase equipment, pay bills, handle payroll, develop new products or services, and so much more. It can also provide a financial picture for where a company is earning and investing its money. 

In plain and simple terms, every business needs working capital to reach its goals. From networking capital, to short term, the importance of working capital cannot be overstated.

What is Working Capital and What is the Importance of Working Capital?

Working capital is more than just “money”. It is an important financial metric that identifies the current operational efficiency, liquidity, and short term financial health of a business. If you want to know how to calculate working capital, the formula is:

  • Current assets - Current liabilities = current working capital

In more basic terms, working capital is the difference leftover when a company subtracts all its liabilities from all of its assets. For example, if a company has $800,000 in assets and $600,000 in liabilities, its working capital is $200,000. In order to get a clear picture of a company’s working capital, you need to understand the assets and liabilities that go into the equation, also known as the components of working capital.    

What are the Four Main Components of Working Capital?

Sometimes people think there are only two components of working capital, assets and liabilities. While that is technically true, it is generally agreed upon that the better way to think about working capital is in terms of four main components. So what are the important components of working capital? Let’s take a look at each of the big four components of working capital with some examples.

  1. Cash and Cash Equivalents - Since one of the major factors working capital assesses is liquidity, it makes sense that looking at cash and cash equivalents is part of the process. Cash can be available funds in a bank account, either form of cash reserves. Cash equivalents are other assets that might not be liquid in this exact moment, but can easily be turned into cash without a steep drop in value. These include things like:

    1. Money Market Accounts

    2. Stocks and Bonds

    3. Treasury Bills

    4. Certificates of Deposit

It is important to take stock of your immediate (or nearly immediate) liquidity because ultimately cash reserves can get a business through emergencies and make instant purchases, like equipment upgrades. More than that though, depending on your financial strategy, you may identify that you have too much or too little cash on hand. If that’s the case, there are steps you can take to remedy either situation. 

  1. Accounts Receivable (AR) - Accounts receivable is another type of asset, but is not as liquid as cash. They are just money that is owed to you but has not been received yet. They can also be checks that you have received but haven’t cashed or deposited yet. Some other examples of accounts receivable include:

    1. Unpaid and open invoices, since most companies offer a 30-day pay period during which time money might be owed but not received.

    2. Outstanding lines of credit would fall under accounts receivable until whomever you extend credit to pays you back.

    3. Accrued interest is another form of AR since it is charged on money you have not yet been paid.

One of the main reasons it is important to understand your accounts receivable is that, unlike current cash on hand, AR tells the story of what you have sold lately and what money you can count on to be coming in within the next month or so. 

  1. Inventory - Many businesses sell tangible goods and items, meaning they have to have inventory before they can deliver it to their customers. While inventory is not something you can spend, because it can be sold and should maintain its value, it is considered a liquid asset and is part of the working capital equation. Inventory includes:

    1. Items on display in a shop or storefront

    2. Items stored in a warehouse

    3. Items already purchased from a supplier that is in transit

Understanding your inventory is important since inventory for a couple of reasons. First and foremost because inventory is liquid, it’s a key aspect in determining your overall current liquidity. Secondly, however, you may also get a better understanding of whether you need to spend more or less on inventory for where your business is currently at. 

  1. Accounts Payable (AP) - Finally we arrive at the liabilities portion of the working capital arithmetic. For accounts payable, you should add up all of the costs you expect to owe within the next year. Generally speaking, long-term payments that are due after a year are not considered a part of your working capital calculations. Some of the liabilities included in working capital are:

    1. Supplier invoice payments yet to be made for goods and services already received

    2. Dividends to shareholders that are or will be due in the next 12 months

    3. Operational expenses such as rent, employee payroll, material costs, overhead, etc.

    4. Upcoming tax payments, due either in the next few months (if you pay quarterly taxes) as well as the next year

    5. Debt repayments including principal and interest such as mortgages, loans, lines of credit, and other forms of borrowed funding

Knowing the landscape of your accounts payable is important because it encompasses an entire half of the working capital equation. Understanding your accounts payable also helps you understand how much money you will be spending, when, and if you have the capability to handle it all. 

Once you have calculated all of these components, you can easily figure out your working capital. It is important to know how much working capital you have for a few reasons. For starters, understanding your working capital also means you understand the financial state of your business. Additionally, working capital is also a large determinant of whether your business can grow, or if an injection of funding will be required to take the next step as a company. 

Types of Working Capital

There are multiple types and characteristics of working capital, and they don’t all mean the same thing. Classifications of working capital are often based on two variables, concept and basis of time. A few of the types include:

  • Net Working Capital

  • Gross Working Capital

  • Permanent Working Capital

  • Short-Term Working Capital 

Let’s look at each one a little more in-depth.

Net Working Capital 

In most instances, when someone refers to working capital, they are referencing net working capital (which is what this blog has been describing so far). As you may have deduced, the term “net working capital” refers to the net difference between assets and liabilities. Again, the importance of net working capital is that it enables a lot of what businesses do from sustaining to growing. 

Gross Working Capital

Gross working capital refers to the total amount of assets within the company at a given point in time. Essentially, gross working capital is the “assets” half of the working capital equation. It is important to have gross working capital and to understand it, but it should not be used as the sole measurement of business health. 

Permanent Working Capital

Permanent capital refers to the minimum amount of cash and assets necessary to cover all of your current liabilities. Naturally the more a company grows, the more its permanent working capital will grow as well. Permanent working capital is an important metric because it’s essentially the assets needed just to stay afloat. 

Short-Term Working Capital

Short-term working capital refers to the amount of capital required to meet an organization’s short term needs. This might include seasonal needs or specific variables or projects that require more capital than your permanent month-to-month needs. For example, purchasing a new piece of equipment or renovating a working space might require the need for more short-term capital. 

What is Working Capital Management?

Working capital management entails optimizing the relationship between an organization’s assets and liabilities. The objective of working capital management is to design a business strategy so that a company can cover its daily costs of operating while also investing in assets in the most effective way. A well-run business will strike a balance between covering short-term current liabilities and planning for long-term future liabilities with proper working capital management. For example, unnecessarily spending all of the cash on hand in the short term does not bode well for long-term goals and success. 

Sources of Working Capital

Now that it is clear how important working capital is, it’s time to figure out where it comes from and how to make sure your company has enough. There are multiple ways to procure funds, but some of the most common ones include:

  • Issuing Shares

  • Getting a loan from a financial institution

  • Retaining earnings

  • Selling capital assets 

  • Securing a line of credit

The thing is, with many of these (and other) common forms of financing, it takes a while to actually be able to see and use the money. Between legal proceedings and other processes, it can be days, weeks, or even months before the funding is actually available to help your business. A lot of times, when businesses need to borrow money, they need it as soon as possible. That’s where Backd enters the equation.  

Secure Fast Funding with Backd

Backd understands the role small-medium businesses play in the economy. Unfortunately for many of those businesses, securing financing is an arduous process. Backd’s goal is to make it quick, easy, and possible for every entrepreneur to get the funding they need when they need it. Backd offers competitive rates, same-day decisions, speedy applications, and flexible terms.

All you need to apply is:

  • Be in business for over a year

  • Have a personal credit score of 600 or higher

  • Minimum annual revenue of $300,000 or more

  • 10 months of deposits in your bank account

After all the qualifications are met and the application is filled out, the team at Backd handles the rest. Apply now today!

What would you do with the right amount of capital?

Working Capital Advance

Easy payment structures offer amounts with fast turnaround, Simple and easy process to access working capital.

  • Flexible - no collateral required
  • $10K - $2M
  • Terms up to 16 months
  • Automatic daily or weekly, or semi-monthly payments

Business Line of Credit

Get instant access to revolving credit with unlimited terms, and the best rates for your business.

  • Draw funds anytime
  • $10K - $750K
  • Unlimited terms, incredible rates
  • Soft credit pull that doesn't affect your credit score