What is Working Capital & Why is it Important?

Image by tonodiaz on Freepik

When it comes to financial metrics like working capital, we can’t negate their influence on the realm of business.
But if the concept has you scratching your head in confusion, you’re not alone. This admittedly elusive accounting term is somewhat of a mystery to anyone not in business, or simply, if you are just not that interested in finance. Nonetheless, the importance of working capital in business cannot be denied – and it’s something you will learn a great deal about if you complete a tertiary qualification like a Diploma in Business Administration or completing an internship. 
So in the end, what is working capital? And why is it so important? If you’re keen to learn more, stay with us as we discuss the concept in further detail. 

Working Capital: What is it, Exactly?

If you’re unfamiliar with the notion of working capital, let us enlighten you.
Working capital refers to the ratio between your business’s current assets, and its current liabilities. In layman’s terms? Consider this the difference between how many dollar bills you’re holding in your hot little hands (or, for example, the funds that you have stored in your bank account, or tied up in your business’s stock inventory – basically, anything that can be turned over to cash quickly), versus how many outgoing costs or expenses you need to cover. 
For many businesses, some of the most common outgoing costs – or liabilities – can include:

• Payroll of employees’ wages.
• Purchasing manufacturing and production materials.
• Paying suppliers and manufacturers.
• Hiring inventory storage warehouses or shopfronts.
• Financing business debts and loans.
• Paying government taxes.
• Any other business overheads and expenses.

For your working capital to be considered healthy, you need to make sure that the assets you have in your possession outweigh your business liabilities. Some financial advisors even strongly recommend that the sum of your assets should be double the cost of your liabilities. 
Not sure if this is the case for your business? Here’s a handy formula to help you calculate your working capital: 
Divide your current assets by your current liabilities. For example, if your company’s current assets can be calculated at $1 million, and your business liabilities are at the $500,000 mark – your working capital ratio is 2:1.
But why is this important, though? For starters, if your working capital ratio is below a score of 1, your company could be at serious financial risk.

Yes, Working Capital is Important – But Why?

If your business’s working capital ratio is low, you could be in risky financial territory. Working capital is essential not only to understand how much room you’ve got to work with financially but also, to assess your outgoing costs. If the latter outweighs the former, you’ll need to make some changes, and fast.
So ideally, how much working capital do you need? In the end, this depends entirely on your business goals. But if you want to maximise your growth, operate your business at optimal efficiency, and have a strong grip on your business’s financial health, you need to have a solid working capital ratio of at least 1.5 to 2. 
For financially savvy business owners, having a good understanding of your working capital ratio can help you to operate, oversee and grow your business more efficiently, as well as to ensure that you always have enough cash on hand to cover your costs and liabilities.

Implementation and Functions: How to Call on Working Capital to Benefit Your Business

So, how do you maximize and improve your working capital? Here are some strategies:

• Make sure your clients pay you on time so that you have a constant, predictable cash flow.
• Stay on top of your invoicing by sending out all of your client invoices promptly. There’s no point chasing clients for payment if you’ve only just sent them an invoice.
• Shorten your invoice payment terms. For example, try reducing the payment cycle from Net 60 to Net 30 to get your clients to pay sooner.
• Lastly, encourage your clients to pay ahead of time by offering early payment discounts and promotional offers. Conversely, you can also stipulate that you will enforce late payment fees if clients don’t pay their invoices or bills on time.

Understanding and managing working capital is vital for the financial health and operational efficiency of any business. Effective management ensures that assets sufficiently exceed liabilities, providing a safety net and room for growth. Ultimately, by maintaining a healthy working capital ratio, business owners can not only sustain operations but also pave the way for expansion and increased profitability. Therefore, grasping this concept is indispensable for anyone involved in business management.