Cash flow in any business enterprise is critical. But getting tied up in stock capital can lead to lost opportunities and even less room for growth. Eventually, you’d need funds to meet your everyday operations. This is where working capital comes into the picture. It is an operational capital that meets your day-to-day financial obligations or commitments.
Working capital is required for a host of reasons like –
- To pay off suppliers
- Maintenance costs
- Replenish stocks
How is it calculated?
In an accounting sense, it’s the difference between current assets and current liabilities. Currents assets involve inventories and receivables while current liabilities are like accounts payable or other forms of short-term liabilities.
- Current assets: It’s what a company owns as both tangible and intangible assets. Current assets can include liquid marketable securities like stocks, mutual funds, bonds or ETFs. Current assets don’t include illiquid assets like real estate or hedge funds.
- Current liabilities: It includes all debts and expenses that are payable in less than one business cycle. It includes operational costs like rent, supplies or interests on debts, etc.
How to fortify your business with working capital formula?
After calculating your business’s operational capital, you might find these scenarios –
- The best case scenario is a circulating capital ratio of 1.2 and 2.0. It is a good sign as it indicates your business is running smoothly and that it has enough cash to meet your short-term obligations other than daily operations.
- You might find that your current liabilities are equal to that of existing assets. It signifies you just have enough operating capital to cover your immediate obligations.
- Worst case scenario, you might find out that you’re running a negative circulating capital and you’re falling short of meeting your obligations.
What determines this circulating capital requirement?
Mainly 3 factors calculate your business working capital’s requirements –
- Receivables – These are debts owed to a firm by its beneficiaries for products or services that they’ve used but not paid for.
- Inventories – These are raw materials needed to manufacture goods.
- Payable – It’s a firm’s obligation to pay its short-term debt to its suppliers.
What happens in the absence of this capital?
- Without adequate operational capital, a business entity can’t cover its short-term liabilities on time. You can use working capital finance to strengthen your business in such circumstances.
- A business with a healthy circulating capital can avail finance easily from the market from its excellent reputation.
- Adequate operational capital maintains an uninterrupted flow of business operations by supplying payment for wages and raw materials.
Furthermore, it provides immediate funds to cover unforeseen contingencies thereby helping an enterprise to run successfully in a crisis period. Thus, it is imperative you have a steady flow of circulating capital at hand.
How to improve operational capital?
By calculating receivables, inventories and payable by working capital formula, a company can enhance its operational capital. For instance –
- Screening potential customers by their creditworthiness and monitoring their financial developments.
- Critically examine the outstanding debts owed and ensure there is transparency between sales and the finance department.
Furthermore, there are alternate ways like optimising stocks to suit market conditions and strike a more extended payment period with lenders.
Pre-empting the working capital your business will require is perhaps one of the most important steps towards successful operations. As a business owner, you need to maintain an above-sufficient amount of such funds to optimise and streamline your business operations.