Understanding working capital - everything you need to know

May 21st, 2020

What is working capital, why it's important to your business and how to improve it.

Are you looking to keep your business afloat during these difficult economic times? Perhaps you’re searching for ways to grow your business, or to start to take advantage of bigger contracts? Whatever your goals are, understanding working capital is paramount to the process.

In this post, we explore how to best understand working capital and why it's critical for your business. We’ll also look into understanding the working capital ratio (current ratio and quick ratio) and how to improve your working capital in these uncertain times.

What is working capital?

Working Capital, sometimes also called Net Working Capital, is one of the fundamental building blocks of business finance. Effectively, it funds the day to day operations of your business. It is the difference between a business’ current assets and current liabilities, and it is a measure of a business’ liquidity. 

Working capital = Current assets - Current liabilities

Current assets include:

  • Cash or cash equivalents
  • Accounts receivable
  • Inventory (that you can convert to cash within a year)
  • Marketable securities
  • Prepaid expenses

Current liabilities include:

  • Wages payable
  • Income tax payable
  • Deferred revenue
  • Accounts payable
  • Accrued expenses
  • Short term debts (payable within a year)
  • Current portion of long term debt

You should always aim for your business to have positive working capital, though it may not be possible 100% of the time. This means that you have more current assets than you have current liabilities. In other words, that you are able to meet all of your business’ operating requirements.

If you have more current liabilities than you have current assets, you have negative working capital. This unfortunately means that you may have trouble repaying existing business loans, or meeting operating expenses. 

Current ratio and quick ratio

The current ratio and the quick ratio are measures of your business’ financial health:

  • Current ratio = Current assets / Current liabilities

This is a somewhat broad measure of liquidity, as it groups together all current assets and current liabilities even though they have different levels of liquidity. As a rule of thumb, a number greater than 1 for the current ratio shows that a business has positive working capital. However, having a large number isn’t ideal either. A number greater than 2 may show that your business has too much money tied up in inventory for example.

A ratio of between 1.2 and 2 is usually considered to be a strong position to be in. 

  • Quick ratio = ( Cash + Accounts receivables ) / Current liabilities

The quick ratio - also known as the acid test ratio - isolates the most liquid assets to gauge liquidity.

The quick ratio can give a clearer idea of your business’ health, because selling non-liquid assets quickly, like old inventory, may not always be possible or may be less than desirable for your business.

Because it discounts selling inventory as either a simple or viable option when it comes to paying short term liabilities, the quick ratio is considered to be a more conservative measurement. 

Evaluating working capital, the current ratio, and quick ratio

A business’ working capital and financial health measurements depend on a variety of factors. So when evaluating your financial metrics it is useful to compare it both against your own business, and against similar businesses in the same industry. This allows you to view them in context. 

Knowing how your own measurements have changed over time will help you to assess your strategy. For example, if your current ratio has been steadily increasing, then it could signal a need to investigate the drivers and make some adjustments to your balance sheet. Similarly, it is useful to keep tabs of where your business stands against peers. If you have a low current ratio and compete in an industry with high current ratios, such as manufacturing, then having this information can help you determine if changes need to be made to increase your working capital to keep production moving.  

3 top tips for improving working capital

Tips for keeping your working capital positive include:

1. Invoice financing

Invoice financing can be a great way to increase working capital. If your debtors aren’t paying you on time, your working capital will suffer. Unlocking the capital that’s tied up in your unpaid invoices can really help to keep the process as smooth as possible.

Many modern invoice financing providers, like Earlypay, also provide a non-disclosed service that integrates directly with your accounting software. This means that you don’t have to tell your customers that you are using an invoice financing provider and bookkeeping is simple. 

You can also utilise easy-to-use receivables management tools that help you get your invoices paid more quickly, so you don’t pay more interest than you need to. We covered some useful tips on best practice receivables management in a previous blog.

2. Manage your accounts payable

Maintaining an efficient accounts payable process is another way to improve your working capital position. Using a digital solution for invoicing and receipts will help your business to accurately record, track and forecast your cash requirements and reduce potentially costly manual input errors, saving time and money. 

Vendor management is also important, so strategies such as staying abreast of vendor offerings and standardising the way you evaluate vendor performance, can give you the information you need when it comes time to renegotiate your terms. 

And just as you need to be paid on time, so do your suppliers. Paying vendors on time not only maintains a positive relationship with the people you do business with, but it also allows you to potentially negotiate better deals or take advantage of discounts. Or, at the very least, to avoid any potential penalties for late payment. All of which can contribute to an improvement in working capital. 

3. Manage inventory 

When considering your business’ inventory, it’s important to closely monitor what you buy, as well as what you sell. Having too much stock places a burden on your current assets, whereas having too little will lose you sales. Depending on the type of product you sell, your stock may end up wasted, or cause you excessive additional costs in storage.

It’s a good idea to conduct periodic stock checks in order to monitor levels of stock effectively. This way, you can alert your finance team to any notable overstock or understock issues that might be prevalent within the business.

Closely monitoring your business' working capital levels using the different measures discussed will help you maintain the right level of liquidity for your business. This will not only ensure that you have liquidity to keep operations moving but will also give you the opportunity to grow when new opportunities arise.

If you think that your business can benefit from Earlypay's modern debtor finance facility and would like to find out more, please contact our team today on 1300 760 205.

If you'd like to learn how Earlypay's Invoice Finance & Equipment Finance can help you boost your working capital to fund growth or keep on top of day-to-day operations of your business, contact Earlypay's helpful team today on 1300 760 205, visit our sign-up form or contact [email protected].