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Understanding Working Capital

understanding working capital

There are many ways to measure the well-being and success of your business. Profitability, a growing customer base and customer satisfaction are a few of the things you should understand and use to determine the health of your business. It is also important to understand what working capital is and why it is an important part of the day-to-day operations of your company.

Working capital

The measure of working capital in your business basically lets you know if you have enough money to meet the financial obligations of the company over the short term. The way to determine the working capital of your business is to subtract the current liabilities from the current assets (current assets-current liabilities=working capital). For example, if you have $50,000 in current assets and $30,000 in current liabilities, the working capital of your business is $20,000 ($50,000-$30,000=$20,000).

In addition to calculating the working capital of your company, you can also calculate a working capital ratio. The ratio represents how many times the company can pay off current liabilities using its present assets. To determine the working capital ratio, divide the company’s assets by the liabilities (current assets/current liabilities=working capital ratio). For example, if you have $50,000 in current assets and $25,000 in current liabilities, the working capital ratio of your business is 2 ($50,000/$25,000=2). In the example, the company can pay off its current liabilities 2 times using the current assets. This ratio can be used to measure the short term financial well-being of a company. A company with a low ratio, close to one or less, could be experiencing financial difficulties.

Measure of the short term

An important factor to understand about working capital is that it is a short term measure of the financial status of your business. In terms of working capital, a short term time frame is within the next year. Can you make payroll? Do you have the ability to make payments on your current debts? Will you need to buy a large amount of inventory for the upcoming season? Can you cover the decreased sales during slow months? All of these questions are related to short term expenses and can be answered by calculating the working capital or working the capital ratio of your company.

Consider within context

The assets of a company used to measure working capital include more than just cash on hand. Assets can include inventory and money owed to the business from customers, among others. As you think about current assets, it is important to consider how quickly you can turn those assets into the cash necessary to cover expenses. Generally, you cannot send inventory from your business to the bank as a payment on your business loan-the bank wants money! In a situation where there is a large amount of illiquid assets, the working capital ratio may be within a healthy range but the company could actually be experiencing financial difficulties. The working capital number and ratio are both important pieces of information that must be used within the context of your situation in order to provide an accurate understanding of the short term financial well-being of your business.

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