Getting your head around key numbers, like your working capital, can help you spot risks and know when you’re in a financial position to jump on an opportunity. Find out more.
Working capital is the money your business uses for day-to-day operations. It’s those assets that can easily be turned into cash (eg stock), minus your outgoings and short-term debt. It provides a snapshot of your business’s liquidity.
Your working capital shows how your current assets stack up against your current liabilities. It shows if you’re going to be able to sustain day-to-day operations and meet short term obligations.
By keeping an eye on it, you can also spot opportunities to improve the flow of money into and out of your business.
Positive working capital shows you have more current assets than current liabilities and your business is in a good position to cover your day-to-day operating costs and obligations.
Negative working capital means you can’t cover current liabilities, and you have more cash flowing out of your business than flowing into it.
You can calculate your working capital by subtracting your current liabilities from your current assets. You can find these figures on your balance sheet.
The focus is on current assets and current liabilities rather than long-term assets or liabilities, because working capital is used to gauge the short-term liquidity of your business.
Current assets are short-term assets like cash, or other assets that could usually be converted to cash within a year. They can include things like:
Current liabilities are short-term debts and obligations that are due within a cash conversion cycle or a financial year. They can include things like:
Your cash conversion cycle is a measure of how much time it takes to turn your inventory into sales, and then into cash.
It impacts your working capital requirements, because the longer the conversion cycle, the longer you’re waiting to get cash into your business to pay things like salaries or wages, rent and other expenses.
To work out your cash conversion cycle, look at your:
Add together your inventory days and receivable days, then subtract your supplier payment days to get the number of days in your cash conversion cycle.
You can estimate how much working capital you need by multiplying the average number of sales you make each day by the number of days in your cash conversion cycle.
Average sales per day x cash conversion cycle = working capital requirements
If this estimate is higher than what you’ve calculated your current working capital to be you’ll need to look at ways to make up the difference, such as a loan or other financing.
You can look at ways of shortening your conversion cycle by:
Step 1: Calculate your average inventory (your inventory balance will be on your balance sheet)
Step 2: Calculate your average inventory days (the cost of goods sold will be on your income statement)