It would be impossible for a company to only focus on profits. To maintain a healthy balance sheet and a healthy business overall, there are many other factors to consider in addition to profit.
Working capital is one of the factors your company should have a good understanding of.
How is Working Capital Calculated?
Working capital is the amount of assets, such as cash, a business has available after all current liabilities have been accounted for. The following equation is used when calculating working capital.
Working capital = current assets – current liabilities
But there is more to it than just the working capital formula. As noted by the BDC, there are several types of working capital.
1. Permanent working capital
The minimum capital required for a company to operate comfortably.
2. Temporary working capital
The capital needed during specific points of the year, or a specific campaign or initiative.
According to the BDC: “This requirement is considered temporary and changes with the business’ operations and market situations. It may also mean the company will require short-term loans, which will be repaid once the initiative begins to generate cash.”
3. Gross and net working capital
A company’s entire current assets, including but not limited to:
Marketable securities (such as stocks)
Net working capital
4. Negative working capital
This can be caused by current liabilities being greater than current assets.
5. Reserve working capital
If a business was presented with a big change, or uncertainty, it may have reserve working capital – otherwise known as a short-term financial arrangement.
6. Regular working capital
The minimum capital required for a business to carry out its daily operations.
7. Seasonal working capital
The amount of money a business needs during its peak season; not necessary after cash has been collected through sales.
8. Special working capital
Only required during a special occasion, like unexpected events and advertising campaigns.
Understanding Your Working Capital Ratio
Along with knowing and understanding your working capital, you should also prioritize calculating your working capital ratio. In other words, how much working capital you have for every dollar of current liabilities.
A comfortable working capital ratio is between 1.5 and 2 – the higher the better, as this means your company has a higher capacity to repay short-term liabilities with short-term assets.
A company with a higher working capital ratio is in a healthier financial position.
Working capital ratio = Current assets ÷ current liabilities
Although, if your company has a lot of inventory, it is recommended that you remove it from your calculations. Why is this? Well, if you have a higher working capital ratio but the strength is due to inventory, this may mean your cash flow isn’t as strong.
Can Working Capital Ratio be Negative?
Your working capital ratio can be negative; and this would greatly impact your company. According to the BDC: “If the working capital ratio is negative, it means the company does not have sufficient liquidity and current assets to service its current liabilities. The more positive the number, the more ability there will be to service those liabilities.”
When looking at a dollar amount, it is wise for companies to aim for a working capital ratio between $1.50 and $1.75 for every $1 of current liabilities – it is not enough to just cover the bills.
But why is working capital important when it comes to inventory? Inventory has a direct impact on working capital since it is an asset. Furthermore, working capital is based on assets and liabilities so improving it will depend on either decreasing liabilities or increasing assets. As mentioned in Measuring and Managing Inventory: Everything you Need to Know, managing inventory is vital to a company for many reasons.
Setting up a Working Capital Management Strategy
Does your company need to improve its working capital and working capital ratio? A good start is to identify the root cause of existing issues (are margins too low, are fixed costs too high for sales volume, or a combination of both?). To ensure you are accurately identifying root causes you should have a working capital management strategy. But what is working capital management and why is having a strategy important?
A working capital management strategy will allow you to monitor current assets and liabilities and make decisions accordingly. According to a recent article on Indeed, “Good management is a great way for companies to avoid financial problems, increase profits, improve their business value, and have an advantage over customers.”
Here at The Owl Solutions, we can take the stress away from building a strategy. Our supply chain performance management platform can help you organize the data surrounding your inventory so you can continue to thrive by better managing your working capital and working capital ratio.
Owl is a supply chain performance platform built by supply chain pros for supply chain pros.
Learn more about our inventory module here.