Working capital is up there with cash flow as one of the most important parts of building resilience and success in small business. And, like cash flow, the trick is learning how to manage it so you can strengthen and grow your business.
Working capital explained
Simply put, your working capital is your current assets minus your current liabilities.
“It’s the amount of cash your business has after factoring in short-term debts like accounts payable, payroll, tax, and other loans and debts,” explains John White, accountant and business development specialist at Business One.
Your current assets will include your accounts receivable, prepaid expenses and inventory. If, for example, your business has current assets of $80,000 and current liabilities of $50,000, then your working capital is $30,000.
“Working capital provides a snapshot of your business’s liquidity,” says John.
Why your business might need to boost its working capital
John suggests four reasons why your business might require additional working capital:
- Seasonal differences in cash flow are typical of many small businesses that might need extra capital to gear up for a busy season or to keep the business operating when there’s less money coming in. For example, a beach-based swimwear shop is likely to do most of its trade over just a few months and may need to set aside capital to pay the rent through the quieter winter season or fund stock purchases ahead of summer trading.
- Almost all businesses could have times when additional working capital is needed to fund obligations to suppliers, employees and the government while waiting for payments from customers. Think tax, holiday pay or increasing stock levels.
- Extra working capital can help improve your business by enabling you to take advantage of supplier discounts by purchasing in bulk.
- Working capital is essential when preparing for growth in the business or undertaking special projects.
How to manage your working capital
So, is more working capital better? Not necessarily.
“If your working capital is low, your business might struggle to grow,” says John. “But your working capital can also be too high – which is a sign you’re not properly reinvesting your cash. Growth may mean a low amount of working capital, but this is fine, if properly managed.”
The key is to find that sweet spot – enough working capital to help you grow but not so much that it’s sitting around doing nothing.
To help you find the balance, John offers his five key tips:
- Don’t let accounts receivable remain outstanding. Converting your accounts receivable into working capital may require a reform of your methods of collecting customer payments. Not following up on accounts receivable can sometimes be a hindrance as your working capital can get tied up in unpaid invoices.
- Forecast your cash flow. Look at your current financial position then roll that forward to understand how much you’ll need in the future. Taking the time to get an accurate forecast of when you will run out of cash will help you determine whether – or by how much – you need to improve your working capital.
- Manage your cash. It may seem like a good idea to pay your bills quickly as they come, but if you find yourself with minimal working capital it is worth reconsidering how and when you pay your bills. Building good relationships with your suppliers before asking them for longer payment terms is also helpful.
- Get a cash injection if it’s needed. If you don’t have enough working capital, you might want to talk to your accountant about tax financing or consider revolving credit (especially if you are seasonally dependent) or a small business loan.
- Stay on top of your inventory. While buying in bulk has its advantages, it’s still important to consider whether you can afford to sacrifice valuable working capital for products that could take a long time to sell. Do the maths to ensure you have adequate working capital for the remainder of the business cycle before making big purchases.
“While financial terminology can sometimes sound a bit daunting, it’s worth getting a good understanding of working capital. It’s relatively simple and a strong indicator of your business’s ability to manage upcoming expenses,” John says.
And managing it well gives you a better chance of success so that you can make concrete plans for your business, not just have hopes for the future.
And as your business grows, you may need to consider legal requirements and liability considerations related to solvency, John points out – another good reason to understand working capital early and thoroughly.
