Working Capital

What is working capital?

Working capital, also known as net working capital (NWC), is a dollar figure calculated by subtracting a company’s current liabilities, such as accounts payable and debts, from their current assets—such as cash, and accounts receivable. It is used to satisfy short-term debts, and fund the day-to-day operating expenses.

Why is understanding your working capital important?

Calculating and understanding your net working capital is important, because it is a measure of your company’s liquidity, operational efficiency, and short-term financial health. Investors often use a late stage company’s NWC to determine whether or not they’ll invest—so it’s vital that you track it.

One other note: just because a company is profitable, that doesn’t mean it won’t go bankrupt. If the business has bills to pay, but no cash on hand or other liquid assets, it's insolvent and cannot satisfy its short term obligations. 

How do I calculate the net working capital of my business?

To calculate the net working capital of your business, subtract your current liabilities from your current assets. If the result is negative, your NWC is also negative which means that you’re burning capital. However, if the result is positive, your net working capital  is also positive—which means you can likely fund your current operations without additional capital injections. If you’re a startup in this position, consider re-investing the amount above your break even point to fuel  future growth rather than recognizing profits today.

Can you provide a sample calculation of net working capital?

Let’s say AJR Technologies has $100,000 of cash in the bank, $50,000 in accounts receivables and $10,000 in inventory, along with $25,000 in short term debt obligations and $50,000 in accounts payables. The net working capital of AJR Technologies is $85,000.

What’s the difference between a company’s net working capital and its current ratio?

The net working capital and current ratio of a business measure the same things—it’s current assets and current liabilities. With net working capital, the figures are subtracted from one another. With the current ratio calculation, a business’s current assets are divided by its current liabilities. A ratio below one means that its net working capital is negative and may not be able to continue to fund its day-day operations or to satisfy its debts if needed. 

What’s the difference between a company’s net working capital and its cash flow? 

These two metrics are similar in concept, but have drastically different meanings and impacts. 

Cash flow refers to the amount of revenue and expenses that a company generates each month. When revenues exceed expenses, a company has positive cash flow. When the opposite is true, it has negative cash flows. 

Net working capital refers to the total current assets of a company minus its current liabilities. When it has more current liabilities than current assets, the organization does not have enough assets to cover its short term obligations.

A startup can have large negative cash flows, but positive net working capital. That said, a startup cannot have negative net working capital, but positive cash flows.

Why might a business require more working capital?

There are many reasons why a business might need more working capital. For example, seasonal businesses need to purchase their inventory ahead of the busy season, which leads to large capital expenditure. This can lead to short term negative net working capital, until the cash receipts from sales come in and rebalance their current ratio/net working capital. Another example might be a company that is going on an aggressive hiring spree to launch a new product line. Their short term liabilities go up, with the expectation that over the long term their current assets will far outweigh them.

What are some of the most common types of working capital?

The most common types of working capital include: 

• Permanent Working Capital - this is the portion of the working capital that remains permanently tied up in current assets to undertake business activity uninterruptedly.
• Regular Working Capital - this is the least amount of capital required by a business to fund its day-to-day operations of a business. 
• Reserve Margin Working Capital - this is the amount of capital kept aside apart from the regular working capital  for unforeseen circumstances such as natural disasters.
• Variable Working Capital - this is the amount of capital that is subject to change based on changes in the size of the business or changes in the assets of the business.
• Seasonal Variable Working Capital - This is the amount of working capital a business needs during the peak season of the year. 
• Special Variable Working Capital - this is the amount of working capital required by a business to undertake exceptional operations or unforeseen circumstances. 

How can a startup improve its net working capital?

• Boost revenue - this increases the amount of receivables (current asset).
• Sell illiquid assets — this transforms non-current assets into cash (current asset).
• Cut expenses — this reduces the amount of current liabilities.
• Take on long-term debt — This increases the company’s cash balance (current assets) without adding nearly as much to its current liabilities.
• Refinance short-term debt— This reduces current liabilities because the debts are no longer due within a year.

What are the common financing options to satisfy a company’s working capital needs?

There are several common financing options available for satisfying a company’s working capital needs including working capital loans, lines of credit and overdraft facilities.

Working capital loans facilitate the daily operations of any business. They are a form of a revolving facility and are best suited for short-term capital needs. Applying for a working capital loan is straightforward and requires no collateral to qualify. That said, the limit of capital a business can qualify is subject to their turnover and the capital not suited for long-term investment goals.

Lines of credit are a form of recurring loans that come with a specified credit limit. They are best utilized as long-term financing solutions, they are flexible and they have wider credit limits. That said, they come with a lengthy application process, and interest accrues on day one.

Overdraft facilities are offered by banks if an account balance reaches $0 and has pending transactions. Overdrafts are typically only used in urgent situations or when a business has cash flow issues. They are typically only offered to customers of said financial institution and require a lengthy application process.

What are some of the common pitfalls to avoid when taking on a financing option to satisfy your working capital needs? 

• Confusing short-term working capital needs with longer-term capital needs - While it may be tempting to use working capital financing to hire permanent employees, purchase equipment or fund an acquisition, it’s a mistake that’s best avoided. Not only is this type of financing not intended for these purposes, it also isn’t likely your most cost effective financing option. 
• Taking more than you need - we’ve all been there—you get offered more financing than you need with favorable payback terms so you take it. You deposit the funds and start putting them to work—after a month you’ve used about half of the capital and the rest is just sitting there. Taking excess capital is a slippery slope—it's expensive and distracting. Instead of focusing on growing your business, you start to think through what you could do with the extra funds, and each month the balance grows as the interest compounds. 

Our thoughts on working capital financing

While some working capital financing solutions are definitely palatable, others can be downright predatory. Instead of going back and forth for weeks with lenders or banks, consider the more founder-friendly alternative—revenue based financing (RBF). With RBF you can convert future revenues into upfront capital without debt, dilution or restrictive covenants. That said, if you're interested in working capital, get in touch!