Over the summer, we ran a 26-day series on social media called the A-Z of Accounting. Each day there was a brief paragraph outlining topics, phrases and words used by accountants and business finance specialists.
Some topics were read by more people, so we’ve chosen the 5 topics that were most viewed to help explain those topics a little further.
W is for Working Capital
Working capital is the driving force behind healthy businesses. Without working capital it is difficult for a company to operate. Even organisations that have healthy profits and a significant amount of assets can fail without working capital.
If you want to measure a company’s operation efficiency and short-term financial health, then working capital will reveal everything! Businesses with a substantial working capital have the potential to invest and grow.
Basically, it is the difference between the company’s current assets (such as cash, unpaid invoices and stock) and its current liabilities (such as debts or accounts payable, which is payments for services or stock you have received but not yet paid for).
How to work it out
The definition of working capital is ‘current asses minus current liabilities’. Accountants use this metric to work out what funds are available to a business once its financial responsibilities have been met.
Here is a simple way to look at working capital: If your business has £100,000 in assets and your total current liabilities are £70,000, the working capital of the business is £30,000. In essence, the business has that £30,000 available to invest in itself. That could be new projects, expansion into increased production or new markets.
If the figures were reversed, then the business has a shortfall of £30,000. Put simply, in this case there is more cash going out than coming in, so it would be impossible to invest in the business.
Can working capital harm a good business?
One of the reasons for a business not having enough working capital could be due to the speed at which they invoice for work. Or it could be that your main buyer is not paying within the agreed terms.
While your business’s financial year-end might show a healthy profit, but if the cash you need to buy stock isn’t available from one day to the next you can’t plan. For example, you may be owed £10,000 in unpaid invoices one day and you can’t buy the stock you need to make your products. This means you don’t have enough working capital, and that in turn can mean you can’t pay your staff, spelling disaster for even the healthiest of companies.
Improve your working capital
Here are some ways you could improve your working capital:
- Faster Invoicing Terms
- More efficient collection of invoices and late payment enforcement
- Credit checking potential customers
- Better inventory management
- Negotiate better payment terms with suppliers
- Increased financial awareness across all departments