Working capital is a concept that describes a business's ability to cover its short-term operating costs. In order to be financially stable, it is essential that businesses have a buffer of assets (items of economic value) that can be converted to cash to cover their short-term liabilities (financial obligations). This buffer allows businesses to pay rent, salaries, utilities and other costs associated with daily operations.
Table of Contents
- Why Does Working Capital Matter to SMEs?
- How to Calculate Working Capital
- How to Increase Working Capital
Why Does Working Capital Matter to SMEs?
It is important for SMEs to have access to working capital in order to cover their costs as they grow their business. For example, SMEs and startups must be able to pay their employees, rent and administrative costs in order to continue to generate their products. Healthy levels of working capital allow companies to cover short-term expenses while also reinvesting in their growth.
How to Calculate Working Capital
Working capital is calculated as Current Assets - Current Liabilities = Working Capital. Current assets are assets that can be converted to cash within one year. These typically include cash, accounts receivable and inventory. Current liabilities are amounts to be paid within one year. Examples of current liabilities include accounts payable, salaries payable, taxes payable, and debt payable.
A business's working capital ratio is calculated by dividing current assets by current liabilities. While there are exceptions, a healthy working capital ratio typically ranges from 1.0 - 2.0. A working capital ratio of less than 1.0 indicates that the business may have trouble repaying its short-term debt. A working capital ratio of great than 2.0 indicates that the business may not be investing its excess assets appropriately.
|Working Capital Ratio||Interpretation|
|Less than 1.0||Low: business may have difficulty repaying short-term debt|
|1.0 - 2.0||Healthy: business able to repay short-term debt|
|Greater than 2.0||High: business may not be investing excess assets (e.g. cash)|
While working capital is calculated using figures from a business's balance sheet, changes in working capital are also reflected in the cash flow statement. For instance, if accounts receivable increases, the working capital ratio (current assets/current liabilities) will improve but there will be a negative impact on the net cash flow as the cash from these receivables is not yet available to the business. This could result from late payments by customers. Similarly, if accounts payable increases, the working capital ratio decreases, but there is a positive effect on the net cash flow because the business has not yet paid for these charges. This could result from negotiating a longer repayment schedule with suppliers or a landlord.
How to Increase Working Capital
There are several methods to increase a business's working capital. First, increasing profits can increase working capital. This is sometimes possible by cutting costs or increasing production. These methods are much easier said than done. Taking on long-term debt to increase one's cash balance is also an option, though it may be an unnecessary burden for SMEs that specifically need financing for working capital needs. Luckily, there are working capital loans designed for businesses to finance their daily operations and meet short-term cash needs.
Another option for businesses is to negotiate longer payment cycles with entities to which they owe money. For example, an SME could negotiate to push back the date when rent is due or when they pay a supplier for goods. This will increase cash-flows in the short-term, as short-term payables are shifted to long-term payables, while incoming cash is still received.
Businesses can also sell shares of their company for financing. Equity financing allows SMEs to raise financing without taking on debt or paying interest. The downside to equity financing, however, is that it requires the sale of ownership shares.
Finally, depending on your business, you may be able to incentivize customers to accelerate the schedule of your receivables. For example, a discount for early payment may encourage customers to pay in a timely fashion, increasing your available cash and working capital.