Net Working Capital – Introduction
Working capital (also known as net working capital) is a financial metric which represents the amount of day-by-day operating liquidity available to a business. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. It is calculated as current assets minus current liabilities. A company can be endowed with assets and profitability, but short of liquidity, if these assets cannot readily be converted into cash. (Definition from WikiAnswers.com)
Working Capital (WC) is as essential for business operations of your company as blood is essential for the operation of your body. You and your company can not live without either blood or working capital. You will be in serious danger if you don’t have enough in your system. Cash is critical and the King, but working capital is the measure of liquidity of assets that can be converted into cash within an annual operating cycle. Without the ability to convert assets to cash via the sale of inventory, collection of accounts receivable or short term notes, liquidation of investments or other form of conversion the working capital will not become cash.
If assets or liabilities are considered current (meaning convertible within 12 months for creation of cash or use of cash) they are taken into account for computing working capital. The net excess of Current Assets minus Current Liabilities equals working capital. If Current Assets minus Current Liabilities yields a negative number, there is no working capital (there is a deficit of working capital).
What does this mean to business owners and what can they do about it? The seven Cs of working capital management are listed below:
Net Working Capital – First C Of Working Capital Management: Classification
Classification is important for accurate financial statements and the computation of working capital. Make sure that all non-current assets AND liabilities are reflected as such. Otherwise, you may be overstating or understating working capital and this may work against you in the computations your banker may use.
Net Working Capital – Second C Of Working Capital Management: Collectability
Collectability is also critical to consider. If you have notes or accounts receivable listed as current assets that will NOT be collected within 12 months they may be computed as working capital but the liquidity may not be realized. Inventory must also be managed to make sure it is convertible to cash though the sales process. If it is not sold, excess inventory will accumulate. The result is that inventory will not become converted into cash and the value of this element of working capital can not be realized.
Net Working Capital – Third C Of Working Capital Management: Capitalization
Capitalization may be one of the most significant considerations regarding assets in calculating working capital. Sometimes assets are expensed when paid and yet they actually benefit the next 12 months, like insurance premiums. If the prepaid insurance is not capitalized and the expense pro-rated over 12 months, the current expenses may be overstated and current assets understated. This will result in an UNDERSTATEMENT of working capital and the prepaid asset may be overlooked by your banker.
Net Working Capital – Fourth C Of Working Capital Management:
Computation of working capital properly is essential to know if you have enough to operate your business with the cash you will need. Improper computation with inaccurate financial statements can KILL you or lead your banker to think you don’t qualify for expanding your line of credit.
Net Working Capital – Fifth C Of Working Capital Management: Creation
Creation of working capital requires either infusion of capital as equity or long term debt, the sale of fixed assets or increasing profitability. Profitability should be your focus if you don’t wish to raise equity capital, increase your long term debt or liquidate your operating equipment.
Net Working Capital – Sixth C Of Working Capital Management: Cease
Cease the risk of working capital disappearing from your balance sheet. Employee theft (of either: cash, inventory or time), writing off uncollectible receivables (from under-managed accounts or sales to the customers who are not credit worthy) or operating losses (not making a profit) all consume working capital. Guard your working capital.
Net Working Capital – Seventh C Of Working Capital Management: Control
Control is the key to managing your working capital and thereby having a sufficient amount to operate or expand your business. Choices you make within your business can dramatically preserve or increase your working capital, which will fund your needs. These choices made properly will allow your banker to understand that your company DOES meet the requirements for your credit request.
An average adult body requires 10 pints of blood to remain healthy. How much working capital does your business require? Do you have enough to not only stay alive but to grow your business?
As B2B CFO® partners we are experts in the management of Working Capital. If you need help evaluating your working capital or getting a better understanding of what you can do to impact the working capital though any of the Cs listed above, contact one of our B2B CFO® professionals.