A regular stream of cash is the lifeblood of all small and medium enterprises (SMEs). It supports your daily operations, pays you and your employees, and helps you plan future business investments. To ensure you’ll have enough cash for these, you need to set and consistently manage a certain amount of working capital.
In this article, we’ll discuss what working capital means, why it is essential, how to compute it using the working capital formula, and other tips to help you track your capital better.
What is working capital?
Working capital is the amount of money in your business that you can quickly use for your daily operations. With inadequate working capital, you’ll have difficulty in meeting your financial obligations, which can lead to delays and inefficiencies in your business operations.
What is the difference between working capital and net working capital?
While both terms are often used interchangeably, net working capital offers a more comprehensive calculation of the capital that you can use.
Working capital defines your company’s short-term liquidity by taking all your current assets minus your current liabilities. Your current assets are anything owned by your business that is convertible to cash within 1 year, such as:
- Cash equivalents (investments that can be encashed quickly)
- Accounts receivable from customers and trade partners
- Inventory for raw materials and finished goods
Your current liabilities are expenses or debt you must pay within the year, such as:
- Utility bills
- Employees’ salaries
- Payments to suppliers and creditors
- Short-term loans
- Outstanding expenses
Net working capital, meanwhile, is a measure of your company’s overall liquidity. It is calculated by subtracting your company’s total liabilities from your total assets. Total assets are your current assets plus your business properties, plants, and equipment. Meanwhile, total liabilities are your current liabilities plus long-term debts, accounts payable, and other long-term obligations. For the purpose of this article, we will focus on computing for your short-term working capital.
What is the working capital formula?
The working capital formula simply lets you know how much cash you have to cover your short-term expenses and financial obligations. The calculation is:
Current Assets - Current Liabilities = Working Capital
A positive result means your business has enough cash to meet short-term financial obligations. On the other hand, a negative result means you may encounter cash flow gaps soon – and have a hard time paying off dues and expenses. In this case, it’s time to review your expenses and liabilities to identify which contributes to business growth, and which can be cut down to reduce unnecessary spending and risks.
You may also find that you have a higher amount of working capital than expected, and it may be time to reinvest that extra cash back into your business. To figure out if that’s a good move, you’ll also have to find out your working capital ratio.
What is working capital ratio?
Working capital ratio is your asset-to-liabilities ratio. Basically, it tells you how many times you can pay off your current liabilities with your current assets. This is useful in case you don’t hit your sales targets for a few months, if you’re deciding to invest additional money into your business, or making other big financial decisions that can impact your assets or liabilities.
The working capital ratio formula is:
Current Assets ÷ Current Liabilities = Working Capital
The higher the ratio, the more cash-on-hand you have. A ratio between 1.2 to 2 is ideal, as this means you’ll be able to manage liabilities in case of unexpected issues. If the ratio is above 2, this means you have more than enough cash on hand. Some of it can be reinvested back to your company to grow your market, improve efficiency and productivity, or expand your business.
On the other hand, a ratio of 1 or less means that your cash flow is tight. It leaves you no room for adjustment if a client fails to pay on time, or if an unexpected issue comes up. In this case, you’ll need to find another funding source to prepare for any cash flow gaps, such as a working capital loan. This is also a good situation for a revolving credit line: you won’t have to pay anything until you use it, and you only pay interest on the portion that you used.
A working capital example
Say that a company, ABC Enterprises, has current assets of ₱1 million and current liabilities worth ₱500,000. The working capital formula is (current assets minus current liabilities). This means ABC Enterprises has a working capital of ₱500,000.
Another company, DEF Enterprises, has current assets of ₱10 million and current liabilities of ₱9.5 million. Like ABC Enterprises, it also has a working capital of ₱500,000.
Using the working capital ratio formula (current assets divided by current liabilities), ABC Enterprises has a ratio of 2, while DEF Enterprises has a ratio of 1.05. This means that DEF Enterprises is less liquid, and more likely to meet a shortage in working capital.
How to practice good working capital management
Working capital management is a set of activities that business owners and managers can perform regularly to maintain a healthy level of working capital. It involves the efficient use of resources to balance out the moving parts of your working capital: your receivables, inventory, and liabilities.
In our 15 tips to improve your working capital, the most important management tip is keeping a good working capital ratio. As mentioned earlier, a healthy ratio is at least 1.2 to 2. Aside from ensuring your business is liquid enough to pay its liabilities, this also signifies good financial health and efficient handling of your company resources – which means you won’t have a hard time securing additional funding for future growth.
Beyond keeping tabs on your expenses, receivables, and payables, it’s also a good idea to automate your business financing processes. One option is to use free digital tools to ensure you won’t miss payments and billing clients. Another option is to hire dedicated specialists to do this for your company, such as a bookkeeper or accountant. The latter will be more attuned to changes in the government's tax system, so they are the best people to ask if your business is entitled to new breaks and allowances.
Lastly, build up an emergency fund before your business needs it. Getting funding when you already have an urgent need puts you at a disadvantage: you won’t have enough time to research your options, and you’ll be forced to settle for the financing source that can offer you the fastest option – which may not necessarily be the most affordable.
Good working capital management will enable your business to maximize its resources, minimize expenses, and act fast in case of cash flow gaps and other issues. In the long run, watching your working capital closely – in addition to keeping a good working capital ratio – will also help your business expand aggressively and avoid bankruptcy.
How to know if you need a working capital loan
After using the working capital formula, you may find that your working capital is negative – and you have insufficient funds for your day-to-day operations. Late-paying customers, a sudden need to increase inventory, or a new business opportunity may also force your working capital into negative territory, or your working capital ratio down to 1 or less.
A business loan is one of the most convenient options to remedy your working capital concerns. Choose a revolving credit line, which is an always-available type of financing that lets you borrow from a pool of funds anytime you need it. It does not require any pre-payment until used; most lenders just charge a processing fee for every withdrawal, or a one-time convenience fee if you need to withdraw multiple small amounts per month. From our comparison of business loans, First Circle’s Revolving Credit Line is the most affordable non-collateral credit line in the Philippines.
The Revolving Credit Line is collateral-free and offers up to ₱20M of re-usable credit for your various needs. The interest rate for this SME loan starts for as low as 0.99% per month, and you pay interest only on the amount used. Another advantage is it has no processing fees and approves applications in just 2-5 business days. For more information, contact us at firstname.lastname@example.org.