working capital says a lot about your financial health
You can get a sense of where your company currently stands by using the working capital formula to determine your short-term financial health (current assets / current liabilities = working capital ratio).
$2 million (current assets) / $1 million (current liabilities) = 2:1
$800,000 (current assets) / $800,000 (current liabilities) = 1
The working capital turnover ratio measures how efficiently a business uses its working capital to produce sales. A higher ratio indicates greater efficiency. In general, a high ratio can help your company’s operations run more smoothly and limit the need for additional funding.
If a company’s working capital ratio falls below 1.0, it has a clear negative cash flow, which means its current assets are less than its liabilities. The company cannot cover its debts with its working capital and should seek options.
A very high working capital is also not necessarily healthy. Consistent inflow and outflow of cash indicate a company is reinvesting in company growth effectively. A typical working capital ratio should be between 1.5 and 2.0.
Net working capital
Your net working capital tells you how much money you have readily available to meet current expenses.
Net working capital formula:
Current assets – Current liabilities = Net working capital
When focusing on net working capital, the current assets you only need to consider are accounts receivable (money owed to you), short-term assets (available cash) and inventory in stock expected to be converted into cash.
Short-term liabilities include accounts payable (money you owe vendors and other creditors) as well as other debts and accrued expenses for salaries, taxes and other outlays.
Forecasting is another way to watch your financial health. As soon as your business launches, you should closely monitor the movement of money in your organization. You’ll need to acquire an understanding of your working capital needs as they change throughout the year.
This includes week over week, month over month and year over year. You should also have notes of anything that could have an effect on those numbers. For instance, keep a journal of what you do differently, foot/website traffic, how much you spend on marketing campaigns and which local events could impact sales activity.
These projections will help you identify slow times when your cash flow gap is widest, and you’ll be able to make proper arrangements to avoid losing too much money.
Forecasting becomes easier after being in business a couple years. You can make calculated estimates about how much money comes in versus how much goes out, and you can focus more on setting working capital aside for growth.
However, if you’re growing at a fast pace, it can be tough to make accurate projections regardless of what you do.