Working capital is a simple measure which indicates a business’ capability to meet short term operational needs. It ensures that the business has enough cash to pay short term debt as they become due. This is a common measure for assessing the short and medium-term financial health of a company. It may also indicate by how much the business can support growth without resorting to borrowing or another capital raising.
Working capital can be calculated by subtracting current liabilities from current assets. Current assets are assets which are easily liquidated e.g. inventory, cash and account receivables. Current liabilities are the immediate /short term debt e.g. account payables; salary, inventory, and supplies.
Working capital could be either positive or negative.
Positive working capital
Positive working capital means the business is able to meet its short term debt obligations. However, if there is large surplus of working capital (i.e. current asset is more than twice the amount of current liabilities), this means the company is not efficient in turning assets into revenue. If working capital is very low, then the company may run into financial difficulties.
A decline in positive working capital over a long period of time may also be an indicator that the company is heading into trouble. This could be due to decreasing sales or even experiencing unsustainable growth, both of which ultimately impacts the company’s cash flow.
A decline in positive working capital could also mean a business is operating inefficiently. Substantial amount of cash tied up in accounts receivable or unnecessary high levels of inventories may be the cause.
Working capital needs to be assessed on a case by case basis based on the nature of the industry. For example, businesses that are seasonal (e.g. ski equipment rental, hotel resorts) will require larger working capital to stay afloat during the low season.
Negative working capital
Negative working capital is when current liabilities exceeds current assets. It means that the business is running a high risk of not being able to meet its short term liabilities that need to be paid.
Extended periods of negative working capital may lead to bankruptcy and insolvency. Businesses need to appreciate the distinction between working capital and profitability. Even though a business is making a high return or profit, the company could still run the risk of bankruptcy and collapse if it is unable to generate sufficient cash to cover supplier and payroll obligations.
Working capital is not a onetime or snapshot of the financial status of the business but a crucial process of continuous monitoring the company’s financial health. It is crucial that all businesses are in control of their working capital. To help manage working capital effectively, a business can:
- Identifying cash requirements to ensure day-to-day business needs can be met
- Manage debt effectively by shortening the credit terms (potentially with incentive) and extending payment terms
- Continually re-assess inventory levels and maintain optimal levels that can sustain business growth and not anymore – lean manufacturing
- Obtain short-term financing be it overdraft, term loan or invoice trading to overcome identified periods when the business is low in working capital
Nalinee Chinowuthichai is the co-founder of InvoiceInterchange, Singapore’s invoice trading platform, where SMEs can flexibly manage their cash flow by selling invoices to a network of investors who compete to provide cash advances.Find out more about Invoice Trading