One of the figures you will see in a set of management accounts is working capital. What exactly is working capital, however? How is it worked out, what is a good working capital figure, and when should you be worried? This article will answer your questions.
In summary, working capital is a way for you to monitor the financial health of your business by checking if you have enough assets (in the short term) to cover your liabilities (in the short term). In other words, it is not about profits or losses. Instead, working capital is the money your business needs to operate day-to-day
Working Out Working Capital
Working Capital is used to measure two things:
- Short-term financial health
You can calculate the working capital in your business today by using the following formula:
Current Assets minus Current Liabilities = working capital
If this is a low figure, there is the potential you could encounter difficulties paying creditors in the short term. This is because you don’t have enough cash to cover your liabilities. This can lead to problems with cash flow, which is one of the main causes of business failure.
Current assets include cash, debtors, and stock. Current liabilities include creditors.
Here is an example:
- A business has €15,000 in stock
- It has €5,000 owed to it by debtors
- It has €10,000 cash in the bank
- It therefore has current assets of €30,000
- It owes €10,000 to creditors (suppliers)
- Its current liabilities are therefore €10,000
- Its working capital is €30,000 minus €10,000 = €20,000
There is no fixed rule for what your working capital should be, however. This is because all industries and businesses are different.
For example, if your current assets are mostly cash, you may not need much working capital. If, on the other hand, your current assets include stock which will take time to sell, you may need more. Your payment terms are also a factor, particularly if you give your clients longer to pay than your suppliers give you. In this situation, you may need more working capital than a business who gets paid quicker or who has more generous payment terms with suppliers.
In addition, your working capital needs can fluctuate depending on what is happening in your business, the time of year, etc.
Working Capital Ratio
Working capital ratio is another figure that can help give you a better understanding of the financial health of your business. It is worked out with the following formula:
Current assets divided by current liabilities = working capital ratio
The number you get tells you how many times you can pay off your liabilities. If this number is below one, you are likely face difficulties. In addition, a working capital ratio that starts to decline over time might be an indication of a deeper problem.
Working capital is not the only measurement of financial health in your business, but it is one you should become familiar with and should monitor.
For more help and advice with your finances, or anything else to do with your business, please contact a member of the Gilroy Gannon team today.