Covering The Basics of Working Capital
Capital - what does that mean? It’s a word that’s tossed around a lot, but what is it and how do you get it? In short - it’s just money. In order to have a business you have to sell a product or service. And to make those products or services, it usually costs money. The money you need to create your sale-able asset is capital. Specifically working capital is the amount of liquid money you have access to at any given time to run your business. Today we are going to look at working capital.
Business owners quickly get comfortable with a balance sheet. There are assets: things of value that the business has; and liabilities: things the business owes. At the end of the day, if you closed the business, sold the assets, paid the liabilities, what would you be left with? Equity. Equity can be increased or decreased either by putting new money in, taking it out, earning it or losing it. That’s it!
Working capital is a portion of the balance sheet looking specifically at Current Assets and Current Liabilities. So, specifically what liquid assets do you have and can you pay the debts owed in the next year. Working capital is a measure of liquidity. Here is what is involved:
Current Assets: Cash, Accounts Receivable, Inventory - both supplies and finished goods
Current Liabilities: Accounts Payable, including payments due on long term notes within the next year
It is very possible to have little to no working capital, or it to even be a negative, especially for new or struggling businesses. This doesn’t mean you can’t operate, it just usually means you need debt to do it. For example, you may have an operating line that allows you to operate even when you don’t have the cash to do it. This is a more stressful way to operate, of course, because the debt has covenants and limitations. In addition there is an expense to using it, in the form of interest.
Comparing Working Capital to Revenue
How much is the right amount to have? There is a balance between investing cash and liquidity into longer term assets, such as buildings, land or other assets and keeping it to easily fund daily operations. Different industries have different comfortable levels depending on revenue stream, turn of AR, necessity of large asset purchases, etc. One way to gauge your working capital level is to compare it to your annual revenue. Let’s say you have $1MM in current assets and $500k in current liabilities and your annual revenue is $2.5MM a year. You have 20% working capital compared to revenue. You can fund, on your own, about 20-35% of your operating expenses on your own, depending on your profit margin. If cash comes in quickly for your business, that may be adequate. If you have more seasonal revenue, you may need additional capital to make it through.
Take time to figure out what your working capital is and what your ideal level would be. The more you have the greater control you have over your expenses, your future investments and the direction of your business. One piece of bad news: the only way to get more working capital is through profit, or directly infusing the business with cash. It isn’t easy to change working capital overnight, but the benefits are huge.
