Working capital is a measure of a company’s operating efficiency and its short-term financial health. Small business owners should try and maintain a maximum of working capital without impeding the operations of their business. By maintaining the amount of working capital a small business in effect builds security against unforeseen financial problems. This built in security aids in securing financing and a company’s overall business reputation in the marketplace.
Working capital is defined as:
Net Working Capital = Current Assets − Current Liabilities
Positive working capital means that the company can pay off its short term expenses and debt using short term assets. Negative working capital is usually a sign of financial trouble since the company cannot cover its most immediate expenses. In short, working capital represents a company's ability to consistently meet its short term financial obligations.
Working capital is rarely an issue for companies that are operating well and can meet all of their credit obligations. However, even a small change in the economy can change a company’s financial outlook to where they cannot meet even normal expenses such as paying suppliers, creditors, or employees. Most companies are overly focused on earnings and cash flow. However, not having enough working capital means that you don’t the cash or credit to meet your financial obligations. For this reason it is important that owners manage both cash flow and working capital to mitigate business risk. Not being able to meet short term obligations can severely reduce credit ratings, relationships with vendors and a company’s credibility in the market place.
How much working capital a company should have is a function of the company’s operations, the market, the competitive environment and internal factors such as debt load, payroll, and cost of inventory. Most individuals are told to make sure and save at least enough to cover 60 days of personal expenses. Since a firm’s may need to survive through extended down periods, a company should have enough cash or short term assets that in conjunction with operating earnings could cover its operating expenses for about 6 months to a year. Within that period of time, debt financing or other solutions can be developed and implemented, if need be. Business with high inventory turnover (such as fast food franchises or supermarkets) that can turn inventory into cash quickly may need to have less working capital than most firms. On the other hand companies with low inventory turn (such as large equipment manufacturers or specialty retailers) that have less control over turning assets into cash may need to have higher working capital reserves.
As part of the working capital strategy, management should determine its long term cash needs to remain solvent. This also requires tracking and forecasting nonrecurring expenses such as payroll taxes and insurance payments that may not be due on a regular basis. Financial experts comment that many companies forget to include significant nonrecurring payments into the budgeting process, which often leads to reserving an inadequate amount of working capital
One way to ensure reserving the correct amount is to create pro forma forecasts of the income statement and balance sheet from the most current annual financial statements. The new pro forma cash flows should indicate anticipated revenues, expenses, and the asset balances needed to cover short-term obligations. In addition to financial forecasting and to mitigate the risks of an extended period of operating inefficiency or reduced sales, management should review their working capital requirements on a regular basis and have a process to highlight when requisite reserves are becoming too low.
By setting up a simple spreadsheet most small businesses should be able to create a rolling twelve month forecast that will indicate if and when working capital reserves are becoming too low to cover an extended period of financial trouble. In addition to being an excellent management tool, having a pro forma forecast of the business will keep management thinking about the strategies necessary to cover any unforeseen risks and provide a clear picture about how much cash and short term assets need to be available to ensure that the business runs smoothly.
Building business credibility means demonstrating solvency. In addition to helping to build a reputation for consistency, having a significant amount of working capital will also make creditors and vendors more likely to extend you credit even during periods of financial difficulty.