Working capital represents the lifeblood of any healthy business. Many promising businesses have, over the years, found themselves insolvent despite significant assets and healthy profitability. The problem here has been a lack of operating capital, without which no business can survive. This article will explain working capital in depth and its crucial place in the business life cycle.
Definition of working capital
The standard definition of working capital is ‘current assets minus current liabilities’. This financial metric is used to calculate what operating liquidity is available to a business and essentially relates to what cash is available to a business at any given time, once its responsibilities have been met. For example, if a company’s balance sheet shows total assets of £200,000 and total current liabilities of £175,000, then its working capital is £25,000.
What does working capital ratio mean?
Because calculating working capital requires understanding the balance between current assets and current liabilities, some people use the term ‘working capital ratio’ as a synonym for the actual amount in £. This is a common practice even though it isn’t referring to an actual ratio.
Others use it in its correct sense which is to explain the ratio between the proportion of current assets to current liabilities. For example, if a company’s current assets amount to £300,000 and its current liabilities are £100,000 the current ratio is 3:1. Some people feel that a current ratio that is less than 1:1 indicates insolvency.
What is the working capital cycle?
The working capital cycle (WCC) represents the amount of time it takes to turn current net assets and liabilities into cash. As a metric, it helps to pinpoint where capital is tied up in actually running the business before earning a return on it. Companies would, therefore, endeavour to reduce their WCC as a means of improving business efficiency. Common ways to do this would be either collecting receivables quicker or paying people more slowly.
What is Working Capital Management?
Working capital management is a business term relating to the processes around keeping the cash moving within a business. To survive, any business needs to balance the recovery of short-term debts with its own ongoing operational expenses. This doesn’t happen by simple good fortune but by a highly organised managerial accounting strategy which closely monitors the current working capital and adapt the business towards maximising it. In larger businesses, this involves ongoing ratio analysis, inventory management, and management of accounts receivable and payable.
How can Invoice Finance Help with Negative Working Capital or Working Capital Deficit?
It stands to reason that when cash flow is holding the business back, an appropriate source of short-term financing could be a lifesaver. Bank loans or overdraft facilities work for some but, especially since the credit crunch of 2008, banks have become much tougher on who they will lend to. Invoice finance or factoring is, therefore, becoming an increasingly popular option for these cash squeezed businesses. Via this system, businesses sell their invoices to a third party (known as a factor) at a slight discount. This gives them the cash flow they need and can prove an effective method of improving the working capital cycle. For this reason, Business Expert created the UK’s first real time invoice finance calculator. Click here to see how much cash flow might be available to your business within a matter of a few working days.