Don’t Forget About Working Capital

All business owners should be looking at their financial statements on a monthly basis. Most business owners, and understandably so, will look to their income to see if they have generated a profit for the period. A lot of owners that I have encountered are “happy” as long as they see positive income at the end of the month, but what about other items that may not be so apparent?

Working capital is an important component of a company’s overall financial health. If mismanaged, it could cause severe stress and cash flow issues for owners. Technically, working capital is simply a measure of a company’s short term financial health. It can be calculated as follows:

Working Capital = Current Assets – Current Liabilities

There are a lot of different variables and ways you can measure working capital (example being non-cash working capital), but in its simplest form it can be measured using the formula above. Having a positive working capital indicates that a company has the ability to meet its short term liabilities with its current assets. A positive working capital is an important measure should be reviewed on a monthly basis to ensure the business is healthy.

In addition to ensuring that the business can meet its short-term obligations, it’s important to analyze all factors contributing to the overall working capital and identify other issues. For example, by investigating your accounts receivable, you may discover that several accounts are overdue and need to be collected. This may trigger you to call your customers reminding them that payment is overdue, thereby triggering that customer to make a payment. Converting your accounts receivable into cash is very important to ensure proper cash flow into the business. The same goes for inventory. Be sure to maintain optimal inventory levels to ensure no excess cash is being tied up in your inventory that, instead, could be in your bank account.

Paying your vendors on time is important to maintain a healthy working capital. It ensures smoother cash flow management and avoids vendor frustration. Delayed payments or a shrinking working capital balance may be a sign of deeper issues. In this case, you may need to look at your profitability, margins and actual cash flows of the business as it is likely that the business is not generating sufficient cash flow to meet current obligations.

At the end of day every owner should be looking at their balance sheet once a month to assess their working capital position, identify problem areas and ensure that there is no cash tied up in their balances. Doing this will detect issues early in the process and help with cash flow management.

 

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