Whether you are new to applying for a business loan or have done it multiple times, the initial thing that your lender will look at is your working capital. Your working capital is what is left of your current assets after you pay off your current liabilities—it’s essentially your company’s short-term financial health. Lenders want to see strong working capital because it shows them that you can cover any unexpected costs and keep the business running. You should understand the importance of working capital before knowing how to calculate it.
Definition of Working Capital
Working capital is the amount that a company has available after paying off its current liabilities. In other words, it’s the cash that a business has on hand to meet its short-term obligations.
The working capital ratio is an excellent indicator of a company’s financial health because it shows how well it can pay off its debts and maintain enough cash to keep operating.
A high working capital ratio means the company has a lot of cash on hand and can easily pay off its debts. A low working capital ratio means that the company doesn’t have much cash on hand and may have difficulty paying off its debts.
Importance of Working Capital
The importance of working capital is clear as it shows a company’s ability to pay its debts and still have enough cash to keep operating. Lenders look at the working capital ratio when considering whether or not to give a company a loan. They want to see that the company has enough cash to cover any unexpected costs and, at the same time, keep the business running smoothly.
Investors also look at the working capital ratio when considering whether or not to invest in a company. They want to see that the company is financially stable and has enough cash to continue operating if there is a downturn in the economy.
How to Calculate Working Capital?
There are two ways to calculate working capital:
- The first way is to subtract a company’s current liabilities from its current assets. This will give you the cash that the company has on hand after it pays off its debts.
For example, if a company has Rs. 100,000 in assets and Rs. 50,000 in liabilities, its working capital, would be Rs. 50,000.
- The second way to calculate the working capital is to divide a company’s current assets by its current liabilities. This will give you the working capital ratio.
For example, if a company has Rs. 100,000 in assets and Rs. 50,000 in liabilities, its working capital ratio would be 2:1.
What are the components of Working Capital?
The components of working capital are current assets and current liabilities.
- Current assets are cash and anything that can be converted into cash within one year. This includes inventory, accounts receivable, and short-term investments.
- Current liabilities are anything that needs to be paid within one year. This includes accounts payable, short-term loans, and credit card debt.
- The working capital ratio is calculated by dividing current assets by current liabilities.
How Can I Improve my Working capital?
You can improve your working capital ratio by increasing your current assets or decreasing your current liabilities.
Some ways to increase your current assets include:
- Selling products or services on a credit
- Investing in short-term investments
- Increasing your inventory
- Invoice finance guide
Some ways to decrease your current liabilities include:
- Paying off your short-term loans
- Paying down your credit card debt
- Decreasing your accounts payable
If you are having difficulty improving your working capital ratio, you may consider seeking out a loan from a lender. They will usually look at your working capital ratio when considering whether or not to give you a loan.
You can also get help from an accountant or financial advisor to help you improve your working capital ratio. They can help you identify ways to increase your current assets or decrease your current liabilities.
Advantages of Working Capital for Your Business
If you have any business size, knowing the importance of working capital is vital. It can finance day-to-day operations, expand the business, or take advantage of opportunities.
There are several advantages of working capital for businesses:
1. It keeps the business running smoothly
Working capital is used to finance the everyday expenses of the business, such as inventory, rent, utilities, and employee salaries. This ensures that the business can continue to operate smoothly even when there is a temporary dip in revenue.
2. It allows businesses to take advantage of opportunities
Having sufficient working capital gives businesses the flexibility to seize opportunities as they arise. For example, if a business owner sees a good deal on office space, they can quickly take advantage of it without worrying about the money.
3. It helps businesses in tough times
All businesses go through ups and downs, and working capital can help them in tough times. For example, if sales are slow, businesses can use their working capital to cover expenses until the business picks back up again.
4. It gives businesses a cushion
Having extra working capital gives businesses a financial cushion if unexpected expenses arise. This can give business owners some relief knowing that they have the resources to handle whatever comes their way.
5. It can be used to finance growth
Working capital can also be used to finance growth initiatives, such as new product development or opening new locations. This allows businesses to expand without taking a large business loan.
Working capital is an essential metric for any business to track. By understanding and calculating your working capital, you can make informed decisions about allocating your resources to improve your company’s financial stability. Hopefully, this article has helped you understand the importance of working capital and show you how easy it is to calculate.