Working capital is a vital part of any successful business. What is working capital, exactly? It is the amount of money or assets left over after subtracting your company’s current liabilities from its current assets. As an equation, it would look like this:
Current Assets - Current Liabilities = Working Capital
The industry standard defines “current" as within the next year or the next business cycle, whichever is less. There are several types of working capital, but the importance of working capital is the same among all of them. It is what can be used to pay for the business’s day-to-day operations.
To better understand why working capital is so important, you must understand how each part of working capital plays a role in the health of a business.
There are four components of working capital, all of which are important: accounts payable, accounts receivable, inventory, and cash or cash equivalents. Below is an explanation of the components of working capital with an example of each. The example will describe a fictional bike shop called Good Wheels.
Accounts payable are short-term debts that a business must pay to its creditors. When trying to determine the total amount of money owed through short-term debts, make sure to add anything you will have to pay in the next year or so. Anything outside of that time frame will not affect your current working capital.
Some types of items you would factor in when calculating your accounts payable include:
Power or fuel
Upcoming tax payments
Mortgages or loans
For example, Good Wheels would add together their expected power bills for the next year, how much they need to pay to lease their storefront, and the loans they took out to start their business when calculating their accounts payable.
Knowing the number of your accounts payable will help you determine whether you have the means to expand your business or create a new product on top of what you already owe.
Accounts receivable encompass any money owed to your business that your business has not yet received. Among these are:
Accrued interest, even if it has not yet been added to an invoice
Good Wheels would count any payments they have yet to receive for fixing up their customers’ bikes and checks they received for the bikes they sold when calculating their accounts receivable.
It’s important to determine your accounts receivable when calculating your working capital because even though you don’t have that money on hand at the moment, you expect to have it within the next year. Once you receive it, it can be converted into cash you can use.
If your business sells goods, you will want to take them into account when calculating your working capital. Your inventory counts towards your assets because you expect to sell them and turn them into cash for your business. Make sure to count more than just the goods you have on your shelves; you can also count extra goods you have in storage and goods you have ordered but not yet received.
Good Wheels would determine how much their entire inventory is worth, including bikes, bike parts, and helmets, that they have ordered and that they have at the store already. By looking at what they have, they can also determine where they might be spending too much or too little to keep their inventory stocked in a way that meets customer demands.
Cash is great for a business to have because it’s money on hand that a business can use to pay for one-off bills or other operational expenses that arise. Cash equivalents are assets that can be converted into cash quickly without much of a loss in value. These include:
Stocks and bonds
Money market funds
Cash management pools
When Good Wheels calculates the cash they have that can go towards their working capital, they will count what they have in the bank, and what they have in their cash register and safe.
Working capital is important because it allows a business to continue to run even when faced with unexpected financial obligations, such as replacing broken equipment or hiring a plumber to fix a leak. With enough working capital, a business can continue to pay employees, regular bills, and taxes.
Working capital management gives businesses a way to assess their working capital and determine where they can cut costs and invest more so that they can maximize their return on investment. It helps business owners decide on future short-and long-term plans. An entire business strategy can change depending on fluctuations in working capital.
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