If you have a business, you may have heard the term working capital – and you may even use it in your day-to-day life without knowing exactly what it means. After all, it’s one of those things that everyone says entrepreneurs need to have, but what does working capital actually mean?
This is what we are going to discuss in this text: in addition to learning what working capital actually means, you will understand its importance for any business and understand the main types of working capital and how they can contribute to the success or failure of your business. Let’s go!
What is working capital?
Working capital is a cash reserve that any company needs to have in order to be able to cover costs and expenses over time. This account includes expenses for opening a business, bills, renovations, purchasing equipment, among others.
Think about the following: if you have a snack bar, for example, you will need working capital not only to renovate the space, have a counter and a grill, but also to buy ingredients and supplies for your recipes.
It is the working capital that will cover the specific expenses (installation, opening a company at the city hall) and fixed expenses (raw materials, bills) of your company.
As you can imagine, working capital is an amount that needs to be stored, whether in the bank, in accounts receivable or in your company’s cash register. It needs to be considered separately from profit – after all, if you fail to consider it and spend what you have made, the company may run the risk of not being able to pay its bills or operate the following month.
In other words: working capital is the company’s financial reserve, the objective of which is to ensure that the business can continue to operate regardless of profit – these are the resources that make the company “run”, understand?
Working capital VS cash flow
Many people confuse working capital and cash flow, but the two terms are not synonymous. Cash flow is how money is managed by the company, between incoming and outgoing resources; working capital is precisely the difference between what comes in and what goes out.
What are the types of working capital?
As you can imagine, there is not just one type of working capital. In this part of the text, we will talk about some of the main types, so that you understand when you need to refer to any of them. Come with us.
Net working capital
The company’s primary financial resources, including assets and real estate, are taken into account by net working capital. It is the outcome of deducting two additional technical terms:
- current assets ( the company’s goods and products that can be converted into cash in the short term; in other words, they are highly liquid resources);
- and current liabilities (debts and payments that need to be made within one year).
Negative working capital
As the name suggests, negative working capital appears when current liabilities become greater than current assets – that is, when the company does not have enough money to cover its expenses.
Imagine that your total monthly expenses are R$10,000, but you only have R$9,000 in the bank. This means that you need R$1,000 to be able to run the business for another month – and therefore, you have a negative working capital of R$1,000.
Working capital associated with investments
Last but not least, there is the working capital associated with investments, which must be allocated to cover a specific investment – such as the purchase of a new machine or the expansion of your headquarters.
Working capital associated with investments needs to be considered when that investment needs to be paid. Often, it can cause the company’s own working capital to decrease, but in favor of its growth – unlike taxes and fees, for example.
What is working capital for?
Working capital serves to help the company continue operating – it is what will ensure that the company has resources to honor its expenses with the government, suppliers, employees and partners.
Additionally, working capital can be used as a gauge for your business’s health. A negative working capital indicates that the business is having difficulties making enough money to stay afloat.
On the other hand, if working capital is too high, this can also be a problem. This can happen when inventory is excessive or if the company is growing too much without necessarily investing in expansion. Whenever working capital is too high, it may be worth considering whether it is worth investing in renovation, expansion or new business models.
Another way to understand the importance of working capital is that it is a great way to understand seasonality within your market. If you own an ice cream shop, for example, you will probably have a higher working capital in the warmer months of the year, when people eat more ice cream.
How to calculate working capital? What is the formula?
There are several formulas for calculating working capital. The big question, however, is to understand which working capital you are talking about.
Practically speaking, gross working capital is equal to the company’s current assets, which include all assets with high liquidity and rapid cash conversion, including cash on hand, inventories, accounts receivable, and raw materials. Real estate and investments with long-term redemption, for instance, are not included in this since their liquidity is lower.
Net working capital, which is used to assess the company’s financial health, has a simple formula to calculate. As we have seen, it is the subtraction of the company’s current assets from its current liabilities.
In other words: net working capital = current assets – current liabilities.
What is the ideal amount for working capital?
According to Dow, working capital should represent 50% to 60% of a business’s assets, but to find this value, it is necessary to consider different variables.
Among them are:
- sales volume ;
- purchase amount;
- storage periods;
- payment to suppliers.
How to keep working capital healthy?
Now that you understand the importance of working capital, you may be scratching your head to figure out how to keep this metric positive. But don’t worry! Maintaining healthy working capital isn’t that difficult. Experts believe that you need to pay attention to some important aspects of your business, such as:
- balance income and expense accounts;
- organize receipt and payment dates;
- control and avoid default;
- negotiate the term of debts;
- reduce costs ;
- track data and reports in real time;
- take advantage of investment opportunities;
- use technology to help with your accounts.
