It may be financial jargon, but it’s essential to understand what it means and how it affects your business. This article explains everything you need to know.
Net working capital explained
Working capital, also known as net working capital (NWC) is the difference between your current assets and your current liabilities. Your current assets include cash and any other assets that can be quickly converted into cash, such as your:
- Accounts receivable (i.e. customers who owe you money for goods and services you’ve provided).
- Inventory (which can be sold).
- Bank account balances.
Your current liabilities are any short-term obligations that you owe, such as:
- Accounts payable (e.g. credit accounts with suppliers).
- Loan repayments that are due.
- Current staff wages and compulsory super contributions due
- Tax payments due to the ATO.
Fixed assets, long term financial obligations and anything that isn't expected to influence your cash flow in the next 12 months is excluded.
Working capital vs cash flow
They are similar concepts, but they cover different time periods. Working capital is the amount of capital you have available at a specific point in time after factoring in your current assets in relation to your immediate operating expenses and debt repayment commitments (you can calculate working capital with your current assets and current liabilities found on your balance sheet).
Cash flow, on the other hand, covers your cash inflows and outflows over a specified time period (like monthly, quarterly, half-yearly or yearly). It’s sort of like comparing a photograph to a video. Your working capital is the photograph, and your cash flow is the video.
Preparing a cash flow statement can help you identify when your working capital levels will be at their lowest so that you can plan accordingly.
Working capital ratio
A working capital ratio is a financial measure that’s calculated by the following formula:
Current assets divided by (÷) current liabilities.
For example, if your current assets are $150,000 and your current liabilities are $100,000, your working capital is 1.5.
If your ratio is greater than one, you have enough liquid assets and cash to cover all your current payment commitments. However, maximising your ratio to the highest possible number above one isn’t necessarily making the best use of your current assets. You may be able to better invest your assets to grow your business.
On the other hand, if your ratio is less than one, you won’t be able to meet all your current repayment commitments. You will need some form of business finance to help you boost your working capital, like invoice finance or trade finance.
There is no magic number for what your NWC ratio should be. It depends on your specific business needs and goals. Working capital management can ensure the business is operating at the most efficient ratio and requires monitoring of your current assets and liabilities.
Working capital needs
Product retailers, wholesalers and manufacturers tend to have higher NWC needs than service-based businesses. Retailers and wholesalers need to have stock to sell, and manufacturers need to buy raw materials to produce their products. To keep their business moving, they need working capital to invest in stock and materials.
In addition, businesses looking to grow significantly will usually need more NWC than those maintaining their current size. This is because they’ll need to invest in staff, equipment, or marketing to increase their output. Working capital needs can also fluctuate throughout the year, especially for seasonal businesses.
While NWC is essential, you don’t need to fund it yourself. Utilising business finance can be an effective way of growing your business without dipping into your reserves.
The bottom line
Working capital is a crucial business financial health measure that you should monitor regularly. If your level is low, finance options are available to help you achieve your business goals.
If you'd like to learn how Earlypay can help you boost your working capital to fund growth or keep on top of the day to day operations of your business, contact Earlypay’s helpful team today on 1300 760 205 or visit our sign-up form.