What Is Working Capital?
It is important that every business owner understands what a working capital cycle (wcc) is, because it can indicate how fast a company can make a profit. This number, therefore, can significantly help a business owner improve his or her operations, especially an entrepreneur running a startup.
The working capital cycle is a metric that figure out how soon a company can turn its assets into money. By understanding how this works, a small business owner can better manage his or her company cash flow, improve efficiency, and generate money on a quicker time scale.
This article will explain what working capital is, what affects the cycle, and how this can affect a small business for better or worse.
When learning about how to calculate working capital for a company, there are a few important phrases to become familiar with. First, one should become acquainted with the phrase ‘net working capital.’ To understand this phrase, one will first need to know about his or her current assets.
Current assets are items that can be turned into money quickly. ‘Current’ or ‘short term’ is a way of saying one year in the financial world. A company’s current assets may include the following:
- Accounts receivable
- Prepaid expenses
- Short-term investments
A business owner should know that current assets do not include long-term, fixed assets. These might include real estate or equipment.
The next step involves calculating a company’s current or short-term liabilities, which are described in the next section.
A company’s current liabilities are its obligations and debts within a single period. Current liabilities may include the following:
- Vendor bills
- Payroll expenses
- Existing loans
Working capital refers to a business’ current assets net of current liabilities. Essentially, working capital is the assets that a business owner possesses after paying his or her business.
The working capital cycle starts when a business owner gets assets to begin the operating cycle. It concludes when the product or service is sold, converting these to cash.
In the end, the working capital ratio helps a business owner figure out if he or she can afford short-term expenses. Therefore, it is essential that a business owner track his or her company’s finances.
One method of tracking a company’s financial performance is maintaining a balance sheet. This is a financial statement that records a company’s assets, liabilities, and capital. By reviewing a balance sheet, a business owner will be able to see how much working capital they have so that they can adjust cash conversion cycles.
What factors affects the working capital cycle?
Depending on a company’s industry and how it operates, the stages of a working capital cycle will differ. That said, the major elements will always be the same.
When it comes to accounting, a business owner can measure the working capital cycle by assessing how long inventory takes to move, as well as the number of days it takes for a purchase to be converted into cash. This is then subtracted by how long it takes for a business to pay its bills.
For example, the working capital cycle for a retail company might include the following factors:
- Buying raw materials on credit to start the cycle.
- Selling the product over the course of several weeks.
- Collecting cash from credit card sales a month later.
As an example, let us assume that Business A turns inventory into cash within 60 days. The bill for inventory is due every 30 days. Thus, the working capital cycle for Business A is 30 days. This indicates how long the company will be in need of cash.
A business owner will strive to have a negative working capital cycle. In this situation, they will get payment for goods before their bills come due. A negative working capital cycle can be achieved by adjusting various stages of the process. This may include moving inventory faster or asking customers to pay more promptly. It is also possible to increase one’s accounts payable or credit terms. This may be done, for example, by requesting that vendors give a business more time to pay their bills.
One of the most important parts of managing a successful business is knowing how money comes in and goes out of the company’s bank account. Simply knowing that a business is profitable is not enough. Revenues may indeed exceed expenses, but this does not take into account the time it takes customers to pay. While waiting for payment, a company will still need cash to pay suppliers, employees, and lenders.
In the end, a business should aim to shorten their working capital cycle. The faster that a business can convert assets to cash, the sooner the funds are available for a business to use.