What is working capital? Everything you need to know as an entrepreneur!
Running a business can be challenging. There are many different factors to consider, and it is important to have a clear picture of the company's financial situation in order to make informed decisions. One important term that all entrepreneurs should be familiar with is working capital. In this article, we will explain what working capital is and how it affects the financial health of a company.
What is working capital?
Working capital is an economic term used to describe the capital that a company needs to run its business. It includes all assets and liabilities related to the company's daily operations. Working capital can be divided into two main categories: assets and liabilities.
Assets include anything the company owns that can be used to run the business. This can range from cash and bank balances to inventory, stocks and accounts receivable. Liabilities, on the other hand, include all payments that the company is obliged to make, such as supplier invoices, salaries and taxes.
Working capital is simply the money that a company needs to finance its ongoing operations during the year. These items affect the company's liquidity as it operates, which is then reflected in the cash flow in the form of cash inflows and outflows.
What is the difference between working capital and fixed capital?
Fixed capital is money invested in long-term assets, such as buildings and machinery. These assets are used to generate income over a longer period of time. Working capital, on the other hand, is used to finance the short-term costs that are necessary to keep the business running.
Why does working capital matter?
Working capital is important as it is crucial for the day-to-day operations of the company. Not having enough working capital can lead to liquidity problems and, in the worst case, bankruptcy. On the other hand, if the company has too much working capital, it can mean that money that could be used to expand the business is sitting idle instead.
By having a clear picture of the company's working capital, management can make informed decisions about its best use. For example, investing in new machinery or expanding into new markets.
How to calculate working capital?
Working capital is calculated by subtracting the company's current liabilities from its current assets. Current liabilities include accounts payable and other liabilities due within one year.
Working capital = current assets - current liabilities
It is difficult to set a rule for what constitutes good working capital as it varies from industry to industry.
Positive working capital
This means that the company has enough available resources to meet its short-term commitments. If a company has a lot of capital, they also have good opportunities to make new investments and thus expand.
Negative working capital
This means that the company may have difficulty covering its short-term costs. This is usually not a good sign, and can lead to major problems for the company.
What happens if a company has too low working capital?
If a company has too low working capital, it can lead to difficulties in maintaining operations. The company may struggle to pay its bills and may have to sell assets to cover its costs. It can also negatively affect the company's credit rating and make it more difficult to take out loans in the future.
What is the difference between working capital and liquid assets?
Liquid assets include the company's available cash and bank balances. Working capital, on the other hand, includes not only liquid assets, but also other assets that can be converted into money in the short term.
How to improve working capital?
One of the most important things you can do to improve your working capital is to improve your cash flow. If your income exceeds your expenses, you have a positive cash flow. If your expenses are greater than your income, you have negative cash flow. Having positive cash flow is the key to improving your working capital. Read more about cash flow here.
Things that can improve your working capital:
- Improve your cash flow
- Manage your inventory
- Improve your invoicing process
- Negotiate with your suppliers
- Explore financing options
Read more about working capital management here.
Do you need help optimizing your company's working capital? We will help you map your current situation and create a strategy to optimize your working capital. Book a meeting now!