Working Capital: What it is, how it works and what you need to know

Working capital, also referred to as net working capital (NWC), is the difference between a company’s assets and debts. This measurement is used to assess a business’s short-term financial health.

Nearly 30% of small businesses fail because they run out of capital. This statistic underscores how crucial it is to understand how working capital works. 

We’ve put together this guide on working capital to help business operators better understand how they can maximize their funds.

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Understanding working capital

Corporate balance sheets can be littered with calculations. Working capital, which takes into account a business’s most liquid assets like on-hand cash and immediate debts, can help shed light on short-term financial viability. 

A business’s working capital is also an indicator of its operational efficiency. If working capital is net-positive, this puts the business in a position to grow and reinvest in the organization. Negative working capital can lead to issues like inability to pay debts or withstand emergencies.

Many successful businesses have, at one point or another, needed to find ways to raise capital. This could be to invest in research and development, increase the business’s physical footprint, hire new employees or sustain the business through a slow season. Increasing your working capital can be done in several ways, like securing a business loan or raising money from investors (we cover more tactics later in the article).

As an example, let’s say you have a local pressure-washing business. For the past two years, you’ve been bringing in $10,000 per month and kept operations lean by working as a solopreneur and using older equipment. But as you look to grow your client base and become more efficient, you’ll need additional working capital to hire employees and upgrade your equipment.

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Working capital formula

Get a sense of your business’s liquidity with the net working capital formula:

Current Assets - Current Liabilities = Net Working Capital

Using the pressure-washing business as an example, let’s say the business has $150,000 in cash and assets. Assets can include equipment such as vehicles and materials. But the business has a $20,000 loan on the company vehicle and a $15,000 outstanding business loan. This means that the business has $115,000 in working capital to continue operations.

When calculating working capital for your business, consider the following for each category: 

Assets

• Cash and cash equivalents
• Accounts receivables
• Prepaid expenses
• Equipment
• Business materials
• Product inventory
• Intellectual property
• Patents
• Royalties

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Liabilities

• Short-term business loans
• Accrued payroll
• Bills payable
• Accrued expenses
• Operating costs
• Business taxes

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Importance of working capital management

Working capital management is an essential part of running an enterprise. Without it, business owners will likely find themselves in a hairy financial situation where they cannot meet their obligations.

Low working capital may lead to an inability to expand to new markets, downsizing, and canceled investments. Small businesses are more likely to experience labor shortages and feel the lulls and booms of the economy than larger corporations. Sales can be seasonal. Industries can dip. Recessions can hit. Put simply, small businesses with lots of cash or high working capital may find it easier to withstand fluctuations in cash inflow. From covering expenses during off-seasons to enabling a business to operate in the event of an economic downturn, high working capital can safeguard against volatility.

On the positive side of the equation, properly managing capital for your enterprise can quickly manifest itself into positive business growth. You will have more flexibility to reinvest in the business and maintain current operations without spreading resources too thin. In short, high working capital makes it easier to cover the costs of day-to-day operations, avoid debt, and invest in growth strategies.

That said, high working capital isn’t always a positive – it could mean that your business isn’t efficiently reinvesting cash or that you’re not leveraging available low-interest loans.

Here are a few straightforward strategies to manage and increase working capital effectively:

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Convert to electronic payment methods

Use digital payment tools to help streamline your accounts payable and accounts receivable systems. Disorganized, unautomated payment systems can slow down processes and result in human error, leading to inefficiency and decreased reporting accuracy. (Opt for free tools where possible – by using a big bank checking account, for example, you could incur unnecessary fees. Novo offers no-fee business checking accounts for small businesses – apply today!)

Be sure to audit your financial statements regularly to determine whether there are opportunities to streamline cash inflow and outflow.

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Practice practical spend management

Finding ways to cut back on expenses is significantly helpful to your bottom line. You can look at areas to cut back spending like:

• Providing fewer company-funded meals
• Reducing company-related travel expenses
• Negotiating your rent for your office space or cutting back on office space
• Finding a more cost-effective provider for business insurance
• Switching to a more cost-effective financial institution
• Evaluating subscriptions to see what you’re no longer using or what can be replaced with a cheaper tool

Focus on reducing spending without compromising efficiency, morale, or the customer experience.

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Source alternative financing

The recent hike in interest rates has tightened up the economy, and businesses are feeling the pain. Because so many businesses rely on new capital flowing in to run their businesses, those enterprises are left with fewer options to maintain operations when those funds become too expensive.

However, there are ways to continue treading forward without paying exorbitant interest rates on funding. Below, we list a few ways to source affordable financing: 

• Leverage credit unions. Visit credit unions and explore their lending options. Credit unions typically offer more favorable rates on loans – but note that you’ll need to meet their membership criteria to qualify.
• Look to Community Development Finance Institutions. These institutions work to expand economic opportunity to underserved communities and specialize in providing low-interest capital.
• Consider invoice factoring. Invoice factoring consists of selling your outstanding invoices to a factoring company. The company will pay you up to 95 percent of the invoice’s value upfront and the remainder (minus fees) when they collect from your customer. This can be a quick way to improve cash flow.

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Negotiate contract terms

Are you paying your suppliers and service providers upon delivery while awarding clients with extended net terms? It may be time for negotiations on both sides.

Ask suppliers and providers for lengthened net terms. This will likely be easier if you’ve been with your supplier long enough to have established a positive payment track record. And when working with new providers, negotiate flexible payment terms from the start.

For clients, immediately tighten payment windows for new contracts. To avoid ruffling the feathers of existing customers, communicate upcoming net term changes with plenty of warning. 

Successful negotiations with both parties will lead to higher working capital. The more payments that come in before outgoing payments are deployed, the more time you can devote to improving operations rather than compensating for low cash flow.

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Place growth practices ahead of fixed assets

Small business owners often make the mistake of pouring working capital into fixed assets, like a larger location or updated equipment. While these purchases might be necessary, they’re not always the best use of working capital. 

Where possible, commit working capital to growth practices, such as marketing campaigns, to get your business in front of more potential clients. Not only can this be a better use of capital, but it’s also a strategy for improving overall cash flow.

For example, new equipment may improve operations, but its value begins to deteriorate immediately, reducing current assets. On the other hand, a smart marketing campaign that leads to new customers can boost sales (and working capital) – if you invest in strategies like SEO, the impact can be long-term.

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Manage inventory levels

If you run a business where you have to order inventory and hold onto it until customers purchase it, you may consider optimizing your inventory management strategy. Reducing sitting inventory decreases the amount of money you have tied up in inventory and the costs associated with storing it.

Consider:

• Ordering inventory only as needed.
• Using the Economic Order Quantity model, which helps determine the optimal order quantity you should order to curtail inventory costs.
• Using the ABC inventory analysis method to classify inventory items according to their importance.

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Limitations of working capital metrics

Like many other metrics, there are limitations to the working capital metric. First, it’s a surface-level metric that can be manipulated. For example, a company’s assets, such as its accounts receivable, could be overstated to make its financial picture look more appealing.

If you’re looking for other metrics to measure the financial health of your business, consider these: 

• Current ratio: Also known as the working capital ratio, the current ratio is calculated by dividing a business’s current assets by its current liabilities. If the number you reach is above 1, this means you are net positive. If the number is under 1, the business is net negative. This metric is another indicator of liquidity and provides investors with a benchmark to evaluate liquidity.
• Accounts receivable turnover: This figure helps quantify how long it takes to collect on invoices and debts to the business. For this formula, divide your credit sales by your average receivables. You’ll find the number of times you collect a debt. Divide this number by 365 (the number of days in a year), and you will know how long it takes to collect a debt on average.
• Accounts payable turnover: This figure describes how long it takes to get debts paid and is a key indicator of liquidity and cash flow management. For this figure, you will take the cost of goods sold and divide it by your average accounts payable. Take that figure and divide it by 365 to know how long it takes to repay debts.
• Working capital cycle: This metric measures how long it takes for a business to convert resources (including materials, inventory, and accounts receivable) into cash. To calculate WCC, you’ll add inventory days (the number of days it takes to turn inventory into cash) to receivable days (the number of days it takes to collect payment) and then subtract payable days (the number of days it takes to pay off debts). A shorter cycle is typically preferable, as it means your business is able to quickly turn resources into cash.

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Key takeaways about working capital

Working capital is essential to any business, and understanding how you can use it to your advantage will help you run your business — and even scale it. It may seem daunting at first to sit and crunch the numbers, but once you get a handle on where your business sits, you can strategize on how to increase efficiency and maximize your business operations.

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Novo Platform Inc. strives to provide accurate information but cannot guarantee that this content is correct, complete, or up-to-date. This page is for informational purposes only and is not financial or legal advice nor an endorsement of any third-party products or services. All products and services are presented without warranty. Novo Platform Inc. does not provide any financial or legal advice, and you should consult your own financial, legal, or tax advisors.

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