A steady flow of working capital is vital for any business hoping to achieve long-term success. A company can have significant assets and profitability, yet find themselves unable to survive due to lack of working capital.
This guide is for business owners interested in finding out more about working capital and how to calculate it, as well as those searching for sustainable practices that will help them optimise their flow of working capital.
Caption: Working capital is a business’ current assets minus its current liabilities
What is working capital?
Simply put, working capital is a business’ current assets minus its current liabilities. This metric is used to figure out how much operating liquidity (in other words, cash) is available at any given time after the business has met its financial obligations.
For businesses in the retail industry, working capital is essential for maintaining stock levels, investing in marketing, developing new product lines and providing customer support.
Current asset examples:
- Cash/ cash equivalents
Current liability examples:
- Sales taxes payable
- Payroll taxes payable
- Loans & mortgages payable
Working capital deficiency (also known as a working capital deficit) is when an entity’s current liabilities are more than its current assets.
Maintaining good working capital throughout the year can be a challenge, especially when you factor in the costs associated with seasonal peaks and dips. Then there’s the unexpected disruptions like – you guessed it – Covid-19.
So how can a business achieve a steady flow of working capital and what can they do to boost it in times of financial difficulty? Before we explore some of the solutions, let’s take a look at how working capital is calculated.
How to calculate working capital
Working capital is calculated using the current ratio, which is current assets divided by current liabilities. Broadly speaking, the higher the ratio the better: working capital is often used to determine a company’s short term financial health and efficiency.
Current Ratio = Current Assets ÷ Current Liabilities
A ratio higher than 1 means the company’s assets exceed its liabilities, suggesting it’s able to pay off short term obligations and fund day-to-day operations. On the other hand, a ratio of less than 1 is seen as risky by investors and creditors.
Working ratio example
Company A’s balance sheet displays assets equalling £300,000 and its current liabilities total £220,000, so the working capital is 1.36. Company B’s has assets equalling £50,000 and its current liabilities are £10,000. In this case, the working capital is 5.
The working capital ratio changes over time because a company’s current liabilities and assets are based on a rolling 12-month period. However, the exact figure can change on a daily basis depending on the nature of the company’s debt.
Maintaining steady working capital and managing assets enables long-term growth and expansion. The following things can help...
Ways to achieve good working capital
- When there’s no threat to the supply chain, avoid overstocking inventory – cash is a more robust asset.
- Develop a rapport with suppliers – this could help safeguard you, especially if you need to delay payment.
- Factor in seasonal variance and allocate your resources accordingly – failure to do so could be detrimental.
- Have a contingency plan in place for potential disruptions.
- Make intelligent investments to facilitate your company’s growth.
- Arrange faster-invoicing terms and negotiate payment terms with suppliers.
- Manage inventory effectively.
- Instil a company-wide awareness of business finance.
Get working capital finance
Those in need of a working capital boost may be able to apply for working capital finance. Business owners get working capital finance for many reasons, but generally speaking, it’s designed to free up cash for growing the business.
Working capital finance comes in different forms, the most common being:
- Working capital loans
Typically provided over a short to medium term to boost cash.
Flexible business overdrafts are available on the alternative finance market.
- Revolving credit facilities
A pre-approved service of funding that doesn’t require a specific bank account with the lender.
- Invoice finance
A common type of working capital finance for companies that offer credit terms to their customers.
- Asset refinancing
The practice of raising finance through a business’ assets.
- Merchant cash advances
A type of cash advance for retailers, pubs, cafes, restaurants etc.
- Tax bill & VAT funding
Enables the borrower to spread the cost over a 3 to 12 month period, freeing up cash for other things.
Getting your working capital ratio right isn’t always easy, but fortunately, there are a number of dedicated solutions available on the market now. Choosing the right one will depend on your current circumstances and what you hope to achieve moving forward.
The Funding Options team is always here to help. Get in touch with us today, and we’ll tell you what you’re eligible for and guide you through the process.