What is working capital and how to improve it

To improve a company’s efficiency, liquidity, goodwill and financial health, it is imperative to manage the working capital. Despite its importance, many companies underestimate the working capital position of their business, and this can often have a significant impact on growth and profitability. Its importance should never be underestimated.

 

What is working capital?

Working capital, often referred to as ‘the life blood’ of a company, and it’s the cash value used in the day to day running of the business. A company’s working capital position gives an indication as to the short to medium term financial health, as well as having the flexibility, or not, to exploit new, and possibly unexpected, business ventures. To calculate a company’s working capital, you simply subtract current liabilities from their current assets. The final figure will also indicate whether your short-term assets will cover your short-term debts.

 

What is working capital ratio?

Working capital ratio, or current ratio, tells the company whether their short-term assets are of a value that is greater or lesser to their short-term debts.

To calculate this, you use this simple formula;

Working Capital Ratio =  Current Assets ÷ Current Liabilities

A result of less than one will tell the company that their debts are higher than their assets, and that they are in negative working capital. Slightly more than one, then there are enough assets to pay off the debts, leaving a surplus. This is a positive working capital. Anything between 1.2 – 2 is generally thought of as being in a good short term liquidity position. Above 2 indicates that the company is investing strongly in its assets. If the working capital ratio is consistently high it could indicate that the company is carrying too much inventory and/or cash, and is not investing in itself, which could cause problems if they were looking to liquidate current assets on the short term.

 

The importance of working capital

Every business has a credit rating, which tells other organisations the ability of the individual or business to pay for goods and services, and whether the credit risk is low or high. Working capital is a clear indicator to this, which is why managing it well should be the number one priority, as it can affect how the creditworthiness of the business is conceived. Being consistently in working capital negative will decrease the businesses ability to get credit, loans, etc. Being consistently in working capital positive, will increase the ability, and encourage suppliers to agree to more favourable terms.

Net working capital doesn’t just tell of the efficiency and liquidity of a business, but can also identify areas that may need looking at and be improved.

 

Author: Darren Henderson, Finance Manager – URICA.

Experian have partnered with URICA, to provide our customers with information on how UK businesses use supply chain funding to enhance their liquidity and improve working capital management. To find out more about supply chain funding, please click here.

Urica - What is working capital and how to improve it

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Posted on by Katie Hague

Estimated read time: 3 mins

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