Working capital is essentially the difference between your company’s liquid assets and its short-term liabilities. It measures how much your business has on hand to cover day-to-day operations. You can use it as a metric to guide your growth and purchasing decisions. Potential creditors and business partners also consider working capital when judging a company’s stability and creditworthiness.
You can calculate your working capital with the following formula:
Assets – Liabilities = Working Capital
At first glance, it seems there are only two factors that go into working capital; however, it is more complicated when you dig deeper. There are four distinct factors that you should understand when calculating the immediate profitability of your company.
The four main components of working capital are:
- Cash and cash equivalents
- Accounts receivable (AR)
- Accounts payable (AP)
Cash, AR, and inventory are three items in your company’s asset column, while AP is a liability. Let’s examine each of these four elements in greater detail.
1. Cash and Cash Equivalents
Liquidity is an essential facet of working capital, and nothing is more liquid than cash. Whether it’s money in the bank or physical bills, a cash reserve is an asset that provides your business a resource to cover operational expenses as they arise.
This category includes cash equivalents, or assets that can be liquidated quickly without a substantial loss in value. These include:
- Money market accounts—A bank savings vehicle with higher interest rates and stricter minimum balance requirements than a standard savings account
- Certificates of deposit—A savings account that you agree to leave untouched until it reaches maturity, usually between three months and one year
- Treasury bills (T-bills)—A U.S. Treasury Department-backed note with a maturity term of under one year
Stocks and bonds—Public company shares that are freely traded on the stock exchange
- Exchange-traded funds—A mutual fund designed to be more liquid than other funds
2. Accounts Receivable
AR is another class of assets that are calculated into your working capital. They encompass money owed to your business which you have not collected, or checks submitted that have not been cashed. As soon as you receive your payments and process your checks, these funds fall into the cash category.
Examples of receivables that you would factor into your working capital include:
- Open invoices—When you invoice your customers, you give them a period (often 30 days) to pay their debts. This process is known as an AR cycle. Because you expect to collect the funds in the near future, include them in your asset column.
- Outstanding credit—To foster future business relationships, you may choose to extend credit to other companies. Until they pay you back, count this as an asset.
- Accrued interest—Anytime you charge interest, even if it has not been added to the customer invoice, you can include it as AR.
Some businesses deal with tangible goods that they must purchase and store before selling to their customers. During this time before the sale, the products are accounted for as inventory. Because the company plans to sell the goods soon, they are a liquid asset that counts toward the working capital equation.
Be sure to include all inventory, regardless of whether it is:
- On display in a physical retail shop
- Being stored in a warehouse
- In transit from your supplier
4. Accounts Payable
Once you have added up all of your assets, the final working capital component is your business’s AP. Include all of the liabilities that you expect to owe within the next year. Long-term debt payments that are due after this 12-month window are not part of your working capital calculations.
All of the following liabilities are part of the AP component of working capital:
- Supplier or vendor invoices—AP includes payments not yet remitted to suppliers for goods and services received.
- Unpaid dividends—Some companies give investors a share of the profits each quarter in the form of dividends.
- Upcoming tax payments—Whether your company pays the IRS quarterly or yearly, be sure to include expected tax outlays over the next 12 months.
- Operational costs—These expenses will vary from business to business but could consist of supply and material costs, utility payments, and leases on offices or warehouse space.
- Debt repayments—Include all principal and interest payments you expect to make toward your mortgages, loans, lines of credit, and other borrowed funds.
How to Augment Your Working Capital
If these four components are not working in concert to create a healthy cash flow balance, your company will lack the resources to meet its minimum working capital requirements. You will need to explore new ways to cover expenses while fortifying your assets and managing your liabilities.
There are many potential methods to boost a small business’s immediate spending power, including:
- Business credit cards—Although convenient, these funding tools often come with annual fees, high interest rates, and stringent credit score requirements.
- Bank loans or lines of credit—Many traditional lenders demand at least two years of operational history to qualify for their funding products.
- Personal assets—If you have a 401(k) or equity in your home, you may be tempted to dip into these funds to fuel your business. Just be aware that there is a chance you could lose your nest egg, so carefully consider whether you are willing to take that risk.
- The Revenued Business Card—Even if your business has only been operating for six months and has a subprime FICO score, you may be eligible for this unique type of business financing vehicle.
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