What is Working Capital?
Capital is another word for money and working capital is the money available to fund a company’s day-to-day operations – essentially, what you have to work with.
In financial speak, working capital is the difference between current assets and current liabilities. Current assets is the money you have in the bank as well as any assets you can quickly convert to cash if you needed it. Current liabilities are debts that you will repay within the year. So, working capital is what’s left over when you subtract your current liabilities from what you have in the bank.
In broader terms, working capital is also a gauge of a company’s financial health. The larger the difference between what you own and what you owe short-term, the healthier the business. Unless, of course, what you owe far exceeds what you own. Then you have negative working capital and are close to being out of business.
Ratios to Watch
When you divide your current assets by your current liabilities, you get a number that represents your company’s relative financial health. That’s your working capital ratio.
Current Assets/Current Liabilities = Working Capital Ratio
For example, $200,000/$150,000 = 1.33
You want a working capital ratio between 1.2-2. That means that you have ample cash to pay your debts, but not too much just sitting around doing nothing.
A ratio below 1 means you have a negative working capital and are struggling to stay current with your debts.
A ratio above 2 means you have lots of extra cash that you could be reinvesting in the company and are not. If you have extra cash, you’re not making smart choices about your money.
Businesses with Large Working Capital Requirements
Companies that are cyclical or seasonal generally have higher working capital requirements than year-round businesses. That’s because it’s likely that debts still need to be repaid even when business is down or the company is not in operation, which means that more assets need to be banked to carry the business through those down times.
So a Halloween costume store, for example, likely does a brisk business during the fall but then needs capital to carry the business during the times of the year when costumes are not as popular. The same might be true of a farmer’s market or a landscaping business.
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