Working Capital: The Lifeblood of a Business
Working capital is very important to the financial health of a business that purchases product and is given credit terms to pay for that product later.
What is working capital?
Working capital is the difference between current assets and current liabilities. Current means less than a year or within a normal operating cycle. Current assets consist of cash, accounts receivables, and inventory. Current liabilities consist of accounts payable and short-term debt.
How does working capital work?
When a commercial buyer purchases product (inventory), it must expend cash or more likely convince the supplier to extend credit, for say 30 days. The commercial buyer will then sell the product to their customer and book the sale as an account receivable. When that receivable is collected, it converts to cash and the cash is used to pay their supplier.
The more quickly a company can convert inventory into cash, the better it will be for the business. It will likely allow for a higher Blue Book rating and pay description to be reported, allowing the business to acquire product, particularly when supplies become tighter.
It is important to make sure that current assets exceed current liabilities, by a consistent margin, ideally by 2 times – a margin of 1.5 is probably more realistic. Factors, such as business type and operating cycles, need to be considered when determining the proper amount of necessary working capital.
Look at how your company is handling its current assets and liabilities.
A few questions to ask include:
- Are your receivables collectible?
- What terms are you offering to your customers?
- What terms are you being given by suppliers?
- Do you maintain enough cash to handle normal operating obligations?
- Do you maintain a line of credit with a financial institution to access in the event your cash balances dip below what is necessary to pay suppliers within terms?