Owning a business is not an easy thing to do. You need to control and manage a lot of things at once to keep track of all the important things in the business. Doing the financial health check for your business is also a very important thing to do as well. You need to make sure that it has stable income growth so you do not need to worry about taking out loans or getting additional investors to your company.
One of the most common things to cross-check your business’s financial heath is to check the working capital ratio of your company. Some business owners have never realized about all of these things, actually, it is just one of the smallest things you can always manage to know about it. For more details, you will get to know more information about the working capital and how important it is in your business.
What is Working Capital?
Working capital or sometimes you can call net working capital is a type of financial indicator that represents the small difference between your company’s current assets and current liabilities. It is a number that indicates and lets you know how well is your company’s financial health doing because it provides a company’s result in paying its current liabilities using its current assets. So in order to calculate the working capital of your business, you need to know about your current asset and current liabilities. Current assets refer to all the valued assets that a company can turn easily into cash within one year or even less than that.
That means current assets exclude long-term assets including some investments, real estate, and others. Therefore, current assets can be the saving account, high liquid investments such as stocks, bonds or mutual funds, and other exchange-traded funds too. Besides that, it also includes cash, account receivable, inventory, and other short-term prepaid expenses too of your company.
Current liabilities include all debts and expenses that your company will pay within one year or less than this. Moreover, it also includes all the operating expenses that your business tends to spend regularly such as the rent, utilities, materials, supplies, interest, or some other principal payment on the debt of the company.
You can calculate the working capital by subtracting the current liabilities from current assets. Doing this will let you know whether your company is able to cover some debts that your company needs to pay out using the current asset of your company. Another way is you can calculate the working capital ratio by dividing your current asset by current liabilities.
If your company’s working capital ratio is smaller than one that means your business’s financial health is not good. To sum up, the higher the working capital ratio your business possesses; the better financial health of your business in paying all short-term liabilities during a bad time. However, financial advisors mention that if your business possesses a very high working capital ratio that can also mean negative to your business. Because it does not show that your company has not utilized its excess cash in an effective way.
You May Like: 6 Steps to Keep Your Business Finances in Order
Why Do business owners need working capital to operate their business?
You may wonder why working capital is so important to your business and in this section, you will know why. Your business will need your working capital as a daily basic need to pay for regular expenses. If you are able to maintain a sustainable working capital budget for your business, your business’s income and profit are also keep sustained as well. Experts also mentioned that well-planned capital management also helps maintain a smooth operation of your business as well.
Additionally, business owners should take care of the working capital management as it also helps minimize the cost of capital spent on the working capital and helps maximize the return on current asset investment. To put it simply, it likes our individual life. In our individual daily life, we need to collect all the money that we lend to others in order to maintain stable cash to spend on our daily basic needs such as food, petrol, accommodation, and others.
However, the needed working capital amount is different from each other depending on your business sector or industry as well. And sometimes it also varies depending on the policy of each company as well. All of these are due to some factors including differences in collection and payment policies in terms of your business’s account receivable. Moreover, it also depends on the timeline of asset purchasing as well.
To sum up, working capital is an important matter that business owners need to consider as much as possible. It is an indicator that represents the financial health check of your company as well. Therefore, you need to control the minimum and maximum working capital budget for your business as too little and too much also represent unhealthy financial health as well.
Another important thing you also need to limit the working capital budget as a reserve budget to settle all urgent expenses too especially during a bad time in the economy like the recent Covid-19 pandemic happened. That is why a financial expert is needed as a human resource in a company to overlook the risk and opportunity of cash maintenance in a business.
Too little cash or too much excessive cash is not healthy therefore you need to set a healthy range of working capital that is needed in your business. Doing this will allow your company to get rid of financial issues and also grow in long term as well by investing the remaining cash from working capital into business development opportunities.