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Working capital refers to the cash you have on hand to keep your business operating, minus expenses.
The amount of working capital you have will provide insight into the current health of your business. It is similar to — but not the same as — cash flow, which refers to the ability to generate income over a period of time. A business with high cash flow will most likely have high working capital as well, provided outstanding debt or investments are under control.
An ideal amount of working capital is in line with or higher than other businesses of similar size. The ratio of assets to liabilities should always be positive, with a healthy ratio somewhere between 1.2 and 2.0. This means the business has more than enough liquid assets to cover upcoming debts within the year. A ratio less than 1.0 indicates more expenses than the money or assets on hand can meet.
If the ratio is too high it may indicate there is more that could be done to expand the business. If it’s too low, it may be a sign that your business is in trouble and you need to start increasing your cash flow.
The formula for calculating your business's working capital is straightforward.
Assets refer to cash, accounts receivable, inventory, and other assets that could be turned into cash within the next 12 months while liabilities could be things like accounts payable, wages, taxes payable, and long-term debt.
Large businesses can get by with negative working capital because of their experience in making revenue quickly, while small businesses should aim for positive working capital figures.
For example, imagine a business has $120,000 in assets in the form of their property ownership, physical inventory, and cash on hand. There's also $75,000 in current liabilities, to pay wages, utilities and taxes. This puts working capital at $45,000.
Business owners should keep track of their working capital as a way of ensuring they are on track to meet their financial targets and goals and stay afloat.
A Xero Small Business Insight report recently found that half of all small to medium businesses are cash flow negative through most of the year. This number was highest in the months leading up to Christmas and into January.
Different businesses will have different requirements for working capital, and some may need more than others, or require it at different times of the year. Whether your business will need high working capital is determined by three key factors: business type, operating cycle, and management goals.
The kind of services you provide will impact the amount of working capital you need to operate your business smoothly. If your inventory is mostly physical assets, such as retail, then a higher ratio of assets to expenses will be needed, to ensure there is enough stock on hand. This will increase at different times of the year, such as leading up to Christmas holidays, where you might need a cash injection to ensure you can keep up with demand and cover short-term expenses.
In the same way, tourism and accommodation businesses will need a significantly higher amount of working capital in the lead-up to busy seasons, such as Christmas, Easter and school holidays.
On the other hand, if your business deals in intangible services and not physical inventory such as consultants or online service providers, then the amount of working capital will most likely be lower.
The time it takes to produce, deliver and receive revenue is another factor to take into account when considering your working capital needs. If the operating cycle is lengthy, high levels of working capital will be required to ensure expenses and short-term debts can be paid for during the periods when revenue isn’t coming in.
Likewise, if there is a time delay between the rendering of services and payment, you will need to have enough working capital to cover business expenses until you receive your takings. That’s why a mobile EFTPOS machine is a critical tool for every business; it enables you to take payment from the customer on the spot, saving you from chasing up late payments and enabling you to access your funds quickly.
Depending on the short-term goals for your business, as well as how fast you are hoping to expand, you may have higher requirements for working capital. When growing your business you will have increased capital needs as you increase your investment in inventory and accounts receivable on top of costs dedicated to these expansions, including equipment or the costs of market research and other associated development expenses.
If your goal is to expand, there will be an increased need for capital. More money will need to be invested into growing your business, whether that be in infrastructure and additional inventory, or on the costs associated with market research and designs. Conversely, if you are no longer looking to expand, you will have a reduced need for working capital.
As a business owner, it’s crucial to have a good grasp on the amount of working capital available to you as a means to be able to further your business. Sign up to our Business Blog to be the first to receive tips on maximising your working capital.