You may have heard the term ‘working capital’ before, but do you know what it actually means? Working capital refers to the difference between a business’ current assets and current liabilities. It is an instrumental indicator of a successful business and can affect funding, inventory, and long-term growth.
To understand whether your company’s working capital is sufficient, it’s essential to first understand what exactly working capital is.
What is Working Capital?
Working capital, sometimes referred to as net working capital (NWC), measures the difference between current assets and current liabilities. Essentially, it tells us what the business owns minus what the business owes. NWC is an effective tool for measuring a company’s short term financial health and operational efficiency.
Current assets refer to the tangible and intangible goods owned by the company that can be turned into cash. These include things like checking & savings accounts, stocks & bonds, mutual funds, inventory, and accounts receivable.
Current liabilities are expenses or debts incurred by the company within the past year and include accounts payable, salaries, accrued income taxes, and rent.
How to Calculate Working Capital?
To calculate working capital, you measure current assets – current liabilities. This gives you an idea of your short-term liquidity and ability to pay off debts.
However, you can also calculate your current ratio, which is measured as:
Current Assets / Current Liabilities = Current Ratio
For the current ratio, a higher ratio indicates better health. The goal here is to be on par with or above your industry average.
How to Improve Your Working Capital
Whether you are applying for a performance bond or are looking to cover short-term debt obligations, positive working capital is key to ensure your daily business operations run smoothly. Here are some tips to help increase your working capital.
- Improve your accounts receivable. Offer incentives to encourage customers to pay on time.
- Cut unnecessary expenses. Perform an internal audit of your company to determine any unnecessary expenses.
- Avoid stockpiling. Working on a just-in-time inventory basis can help increase your NWC by ensuring your inventory is quickly converting to cash.
- Pay debt on time. Avoid needless expenses to ensure you are not paying penalties and premiums.
While not every obstacle is predictable, preparing will help ensure your business has sufficient working capital in case of financial hardship. Check out this in-depth guide to working capital from JW Surety Bonds to find out more about the importance of understanding your company’s working capital.
