Working capital is vital for every business — quite simply, if you don’t have enough, it can be a problem, regardless of how profitable you’re going to be in the future. For equipment finance, your working capital is assessed as part of your application. Lenders are keen to know what level you have and is it enough as a backstop. Here’s what you need to know, plus some working capital solutions to help you bridge any gaps.
Working capital is the cash — or cash equivalent — your business has available at any given time, minus the money you owe this year. Working capital is calculated by subtracting your current liabilities from your current assets. So, for example, if you have $24,000 of current assets and $18,000 of current liabilities, your working capital would be $6000.
Current assets can include cash, any invoices you have issued, expenses you’ve prepaid and, of course, inventory.
Liabilities are anything you owe, including outstanding invoices, payroll, goods or services you’ve been paid for but haven’t delivered, anything owed to the Australian Tax Office, any short-term loans or debts, plus any portion of long-term debt repayable over next 12 months.
Why is working capital important?
Working capital is a great indicator of the health of your business — and that’s useful for you and potential investors. Companies that end up going out of business usually do so because they can’t meet current obligations rather than being unprofitable.
A good working capital ratio depends on your business. Generally, a ratio of 1 — i.e. you have double the money you owe — is adequate. Below 1 indicates things are tight, while under zero means you can’t repay the money you owe. A good ratio is usually between 1.2 and 2.
If your working capital is high, it may be a sign you’re not reinvesting in the business effectively and missing out on opportunities to grow.
Working capital and cashflow are similar, but not the same. Working capital gives a snapshot of the moment, whereas cashflow is an indication of the money the business can bring in over a specific period. If your working capital is too low, your business could find itself encountering difficulties. A good example of the difference is if you purchase $30,000 of stock — your cashflow would decrease as you spent money. However, your working capital would remain the same as you still have that value of the asset.
Can working capital be low and cashflow be strong?
While most businesses with a high cashflow will also have high working capital ratio, that’s not always the case. Your working capital could be low, but your projected future sales are strong. This may cause short-term issues when it comes to paying bills, but in the longer term, the business looks healthy.
If you need a working capital boost to meet repayments or invest in the business, there are several ways you could approach it. They include liquidating some longer-term assets (for example, selling and leasing back equipment), attracting investment, extending debt terms or taking out some business finance.
Working capital cycles and growth
If you pay suppliers in 30 days, but take 60 days to collect receivables, your working capital cycle is 30 days. The longer the cycle is, the longer your business is tying up capital without earning a return on it. If you balance your incoming and outgoing payments to minimise net working capital, you can maximise free cashflow.
Growing businesses require cash. Being able to free up cash by reducing the working capital cycle is an inexpensive way to grow.
If you would like to discuss your cashflow finance options, contact us today!