What is working capital?
Working capital is the difference between your assets and liabilities over a 12-month period. For example, if you have $250,000 in assets and $75,000 in liabilities, your working capital is $175,000.
Understanding your working capital ensures you have enough cash to pay future bills while providing an overview of your financial health. A positive amount of working capital shows that your business’ finances are healthy, while a negative amount can indicate issues, especially if it’s consistently negative throughout the year.
Why is working capital important?
Working capital is crucial to business survival. Positive working capital helps finance operations, such as buying inventory, paying rent and meeting payroll. Working capital also enables you to manage debts, pay bills on time and have adequate liquidity.
Positive working capital also earns lenders’ and investors' trust and helps establish your credibility. You're more likely to qualify for loans and credit if you demonstrate healthy working capital and repayment ability.
A healthy working capital balance can also protect your business against financial shocks such as unexpected expenses. It can also help your business remain solvent and viable during economic downturns.
Components of working capital
Current assets
Current assets refer to cash and assets you can liquidate within one year or your business year, whichever comes first. It includes money in bank accounts, short-term investments, accounts receivables, notes receivables, tax refunds, inventory and pre-paid expenses.
Current liabilities
Current liabilities refer to any loans and obligations you must pay within one year or your business year, whichever comes first. It includes accounts payable, wages payable, taxes payable, loan interest, loan principals, deferred revenue and other accrued expenses payable.
How to calculate working capital
To calculate your working capital, subtract your current liabilities from your existing assets using the following working capital formula:
Working capital = Current assets – Current liabilities
Let’s take a look at a working capital example:
Company A's current assets total $1.5 million during their business year. This total includes cash, short-term investments, prepaid expenses and inventory. Company A's current liabilities total $750,000 for the same business year, including accounts payable, income taxes and loans.
Using this information, we can determine that Company A’s working capital is $750,000 ($1.5 million – $750,000).
Does working capital change?
Working capital fluctuates throughout the year. Several factors can affect the amount, such as large outgoing payments, changes in seasonal sales and additional loans or credits. Your balance sheet will provide a snapshot of your working capital on a specific date, so monitoring your incomings and outgoings is essential.
Working capital management: 6 tips for managing capital
1. Collect timely invoices
The quicker you send out invoices, the faster you'll get paid. Manage your invoices efficiently by using invoice automation software to create and send invoices.
You can also speed up the process by offering a range of online invoice payment options and by incentivising early payments with discounts.
2. Promptly pay suppliers
Pay suppliers promptly so you always have an accurate reading of your working capital. Plus, on-time payments keep suppliers happy, which may enable you to negotiate preferential terms with them.
3. Manage cash flow
Cash flow management is integral to maintaining positive working capital. To effectively manage cash flow, you must monitor expenses, track accounts receivable and plan for potential cash shortfalls.
You can look into various funding sources like cash flow lending, accounts receivable financing, credit cards and overdrafts if you experience cash flow difficulties.
4. Optimise inventory levels
Keeping your inventory at optimum levels throughout the year is essential for working capital. Too much stock can lead to higher storage and handling costs, while too little inventory can lead to lost sales and customer dissatisfaction. It's critical to balance supply and demand to keep inventory levels sufficient to meet customer needs.
5. Monitor and control costs
Monitoring your costs is the key to controlling them. Keep track of your expenses, identify areas of overspending and take action to reduce them if needed. Regularly review your budget and adjust it if needed.
You can also use strategies like refinancing short-term debt into longer-term debt to lower your immediate liabilities and reduce expenses where possible.
6. Automate accounting
Tracking every asset and liability can be challenging, especially as you grow. Invest in accounting automation to manage your cash flow and reduce your reliance on working capital. MYOB’s accounting software automates your accounting tasks and provides you with detailed insights into your company's finances, including working capital management.
Simplify your accounting with MYOB
MYOB is a business management platform that allows you to simplify the way you run your business and manage your books. With MYOB you can manage your customers, projects, employees, suppliers, finances, accounting and tax, all from the one platform.
Cloud-based, you only pay for the software you need, but you can add to your platform as your business grows and evolves. Manage your working capital with confidence, operate efficiently and stay compliant - with MYOB.
Disclaimer: Information provided in this article is of a general nature and does not consider your personal situation. It does not constitute legal, financial, or other professional advice and should not be relied upon as a statement of law, policy or advice. You should consider whether this information is appropriate to your needs and, if necessary, seek independent advice. This information is only accurate at the time of publication. Although every effort has been made to verify the accuracy of the information contained on this webpage, MYOB disclaims, to the extent permitted by law, all liability for the information contained on this webpage or any loss or damage suffered by any person directly or indirectly through relying on this information.