Working capital: why it’s important to your business

Managing your working capital more effectively can help improve your business' overall financial health.

By managing your working capital effectively, you're helping to make sure that your business maintains adequate cash flow to fund its operations and cover costs for the short term.

This alone can sometimes make all the difference as to whether your business succeeds or fails, so it's worth devoting a lot of attention to.

What is working capital?

Working capital (sometimes referred to as net working capital) is the money your business needs to be able to operate from day to day.

Basically, it's the cash you have left, after you account for money coming in and money going out over any given period.

Why is working capital important?

Managing your working capital successfully is essential if you're to stay in business.

Many businesses that appear profitable are forced to cease trading because they're unable to meet their short-term financial obligations when these payments fall due.

An otherwise profitable, high-growth company may run out of cash because its need for working capital continues to increase. This typically happens when a growing business invests further in inventory and stock, and its accounts receivable (the money it owes for items bought on credit) increase as a result.

How to calculate working capital

The classic formula is:

Working capital = current assets - current liabilities

It can be a positive or negative figure. Generally, the larger your working capital balance, the more likely it is that your business can meet its current financial obligations.

Working capital ratio

This is a simple way to know how many times your business can pay off its current liabilities by using its current assets.

The calculation is simple:

Working capital ratio = current assets / (divided by) current liabilities

A ratio of less than one would indicate that your business is very likely to have financial difficulties, as it appears to lack the cash it needs to service its short-term liabilities.

For instance, although your business might have assets such as buildings, quickly turning them into cash to pay for materials or pay staff will take time.

Working capital: what your business needs

The working capital you need will depend on a variety of factors. One crucial factor is the length of your cash flow cycle - that is, the time it takes to get paid after you've incurred costs in delivering a product or service. Your working capital requirement will include the amount of money you need to cover all your costs while you wait to be paid. You'll also need to have some margin of safety for unexpected costs, such as a tax bill. For example, you'll need to cover your costs:

• for the period during which you're creating your product or delivering your service
• during the period you invoice the customer for the products/services provided
• while you wait for the customer to pay you

Remember, the longer your cash flow cycle, the more capital your business needs. Because of this, you must understand your cycle and how much cash you have tied up in it.

How to better manage your working capital

Having an effective system for managing your working capital can help you not only cover your financial obligations but also boost your earnings. An accurate cash flow forecast will allow you to see what's happening to your cash flow cycle and to better understand what amount of working capital you need. This helps you to make more informed financial decisions.

Getting a shorter cash flow cycle

Here are three ways to shorten your cash flow cycle and improve your working capital management as a result:

1. Reduce your debtor days

In other words, the amount of time it takes for your customers to pay you. This will bring in cash more quickly.

2. Increase your creditor days

This is the amount of time it takes you to pay your suppliers. However, always negotiate this with your suppliers before making any increases.

3. Manage your inventory more efficiently

Only buy things, such as stock, when you need to. It's crucial that your company has enough inventory on hand to fulfil any orders, but not so much that you have an inordinate amount of working capital tied up in your inventory.

Where to find guidance on managing working capital

If you need guidance on improving how you manage your working capital, seek out a qualified accountant.

There may also come a point where your business isn't able to generate the cash it needs. If this happens, you should address any potential shortfall in working capital before it starts to harm the business.

To improve your working capital situation, it may make sense to speak to a company that offers invoice finance, or consider other forms of finance.

If your business is in great difficulty, you can also look to hire an insolvency practitioner.