Working Capital or the measure of a company’s ability to pay off its short term debt is the difference between current assets and current liabilities.
photo credit: Casey Serin
It is critical that you have enough working capital at any moment and here are the reasons why:
Working capital is used to finance the following:
• Construction, renovation or improvements to the leasehold.
• To buy furniture, fixtures, machinery, or equipment.
• To replenish inventory.
• For day-to-day operations of a business and payroll (except owners’ salary).
• For down payment assistance on the purchase of real estate for the business.
There are typically five components of working capital that are important for a small business to understand and monitor:
• Cash and equivalents represent the most liquid form of working capital. Every small business should understand the time dependency between cash inflow and outflow, when peak cash is needed and the level of borrowing needed to meet shortfalls of cash.
• Accounts receivable represents the credit that the business extends to its customers. Small businesses need to know the amount of accounts receivable reasonable relative to sales, how rapidly are receivables being collected, and the slow paying customers
• Inventory can be as much as 50 percent of a small business’s current assets. A small business should know whether the levels are reasonable compared with sales and how fast is the inventory turnover relative to industry trends.
• Accounts payable is the amount of money owed suppliers. Every small business should know whether the level is reasonable relative to purchases and if the payment policy negatively impacts the business’s credit rating.
• Accrued expenses and taxes payable are time obligations of the business and represent a future cash outflow.