Small business owners are great at knowing the product or service they’re trying to sell. They’re familiar with terms and trends of the industry but that doesn’t always crossover into business-speak. Has anyone ever asked you about your working capital needs? Does the phrase “working capital” sound cryptic to you? Did you know that working capital is critical to every business large or small? Let’s take a quick look at working capital to figure out what it is and how we get it.
In simple terms working capital is just the pile of money leftover after paying all your bills. Those bills include costs immediately due like the electricity bill, but also term loan payments that will be due within the next 12 months. Working capital is that extra cushion in your checkbook to get you through a slow season or when unexpected costs arise. Here’s an example of what working capital might look like:
Cash $25,000 Accounts Payable $2,000
Accounts Receivable $5,000 Loan payments due this year $13,000
Inventory $30,000 Line of Credit Balance $30,000
Total current assets $55,000 Total current liabilities $45,000
Working capital = current assets – current liabilities or $10,000 in this example
In this example the business owner has $10,000 of free working capital that can be used to survive the slow season or cover the costs of that sidewalk assessment the city just levied.
So now what? Is your working capital in good shape? There’s an easy calculation you can make called a Working Capital Ratio to figure it out. Simply divide the Current Assets by the Current Liabilities. From the example above it would look like this:
Current Assets / Current Liabilities = Working Capital Ratio or 55,000 / 45,000 = 1.22
In other words, our business owner in this example could pay all the immediate bills of the business 1.22 times over which is to say there is enough money to cover all the bills.
But is a ratio of 1.22 great or not great? Working Capital Ratios generally are defined by the following ranges:
Working Capital Ratio of 2 or greater is STRONG
Working Capital Ratio of 1.3 to 2 is ON ALERT
Working Capital Ratio less than 1.3 is VULNERABLE
By these standards the business owner from the example is in VULNERABLE territory. The bills will get paid but just barely. If any significant costs arise, like that pesky sidewalk assessment, it could jeopardize the business owner’s ability to pay bills.
So how do you increase working capital?
- Increase profit margins to generate more cash
- Refinance loans for a longer maturity and/or lower interest rate
- Reduce unnecessary or discretionary spending
- Convert inefficient equipment to cash
- Convert equity to cash by accepting a new partner or shareholder
Now go take a peek at your balance sheet and determine your working capital. Make it a goal to achieve stress-free cash flow and a strong financial position today!