Do you know what working capital is? Sure you do!
Working capital is a fancy accounting term for the money available to fund the day to day operations of your business.
In a nutshell, your working capital is the money you have leftover after you have paid all of your short term liabilities.
That is, what is the amount of your current assets (cash or those assets those that can be quickly converted to cash such as debtors and stock on hand) minus the amount of your current liabilities (liabilities that are due within around 12 months)?
A worked example:
$80,000 Current Assets ($40,000 Office + $20,000 Inventory + $20,000 Cash)
$65,000 Current Liabilities ($30,000 Wages, $15,000 Rent, $10,000 Accounts Payable, $10,000 PAYG)
$15,000 Working Capital
The adequacy of your working capital will depend on the industry in which your business operates and your particular needs at a point in time.
An important tool to assess your businesses working capital is to establish your “Working Capital Ratio”.
The formula to work out your working capital ratio is:
Current Assets / Current Liabilities = Working Capital Ratio
Using our worked example above
$80,000 Current Assets / $65,000 Current Liabilities = 1.23 Working Capital Ratio
Typically, a business should be aiming for a working capital ratio of somewhere between 1.2 and 2.0. This means it has just enough money to meet its short term liabilities, with a little bit of cash up their sleeve.
- A business with a working capital ratio of above 2.0 has too much money readily available. The accountants would say that the excess money could be reinvested. Use the extra money to make more money.
- A business with a working capital ratio of less than 1 means the business is struggling to stay on top of its debts and the business is in real danger of heading toward financial distress.
Have you worked out your business working capital ratio? If not then now is a good time to do so.
In conclusion, if your business ratio is close to 1.2 or below, consider implementing the following steps in an effort to improve your working capital. Download the Working Capital Boost Checklist.
Working capital health can be complex and there are many levers that can hurt or improve the overall financial performance of the business.
We at Cross the T can help you review your current practices and recommend improvements.
If you would like to discuss this topic, please click on the link to have a free no-obligation meeting with Barry White.