The working capital in your business is the net amount of liquid assets you have in the business, ie. those that can be converted into cash soon; certainly within the next quarter or so. To calculate your working capital, find your most recent balance sheet showing your assets, liabilities and net worth. Next, subtract your Current Liabilities from your Current Assets. If the value you get is positive, you have a positive working capital and if negative, have a negative working capital. Positive = good. Negative = bad. Very bad in fact, as you will struggle to meet your day-to-day commitments and are heading for bankruptcy.
Once you have your working capital number, divide it into your total sales for one year. The value you get is called your Working Capital Turnover. The higher the number, the less cash you have and the more vunerable you are to cash flow problems. Too lower number indicates you have too much cash in the bank and are not investing it properly in your business. So what is the “right” number?
Company A has working capital of $20,000 and does $1,000,000 in sales. His working capital turnover is 50. He has too little working capital for the business, is under capitalized, and will have cash flow problems. He needs to use credit cards, lines of credit and suppliers’ credit to survive. If we divide 365 days in a year by 50, he has about 1 week of money to cover no collections. He is trying to do too much business for the working capital he has and if someone does not pay him, he runs the risk of business failure.
Company B has working capital of $200,000 and does $1,000,000 in sales. His working capital turnover is 5. He has too much working capital, is not using his cash wisely, is not investing in his company, and is too conservative. If we divide 365 days in a year by 5, he has 73 days of money to cover no collections. He has enough money to pay all his bills for 73 days without any Accounts Receivables hitting his door. Certainly safe, but perhaps overly so. He is commonly called overcapitalized. He needs to invest in his business by hiring more people, spending more on marketing, and adding assets.
Company C has working capital of $100,000 and does $1,000,000 in sales. His working capital turnover is 10. He has about the right amount of working capital for the business, is capitalized well, and can probably cover anytime his collections do not arrive in a timely fashion. If we divide 365 days in a year by 10, he has about 36.5 days of money to cover no collections.
So as you can see having the right amount of working capital is vital to the long-term survival of your business. Also using working capital wisely and not to buy long-term assets, such as vehicles and capital equipment. Working capital is for to fund CURRENT activities, not long-term stuff. Calculate your working capital on a monthly basis and use strategies to keep the working capital number in the acceptable range. A very rough rule-of-thumb is to have about 1 month’s worth of sales as available working capital.
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