One concept that is mentioned every now and then relating to business is working capital. In spite of popping up now and then it’s not a concept, we have touched on in-depth so I thought this would be a great opportunity to look at the subject. Just before we start, note that while working capital can look like a very simple concept in a small business but it is worth thinking about some concepts of working capital more widely used in big businesses and we will focus on one of them.

What is it?

Working capital is the capital of a business which is used in its day-to-day trading operations, calculated as the current assets minus the current liabilities. That is to say, money and equivalents that are used in the day to day running of the business. So clearly working capital does not include capital expenditure or items such as machinery but rather items related to the day to day business of the organisation. This can include cash (and equivalents), raw materials, goods in production, prepayments,  consumables involved in bringing the goods to condition, finished goods in inventory and amounts owed to you for goods supplied to customers. Depending on the type of business. From there we would have to subtract amounts owed for any of the materials mentioned or other amounts owed for the purposes of bringing products to the market.

Why is it important?

Working capital, therefore, is the amount of money and short term assets you have available to put towards your business operations. If something is causing your working capital to grow it, therefore, means a greater ability to meet business obligations in the short term as something that affects your working capital negatively would mean diminishing your ability to meet your obligations. Imagine a vendor who sells bottled water buys a case of water and it sells out. Assuming the vendor makes double their money the next day they decide to buy 2 cases but now the vendor has no transport money. Ignoring transport costs in the working capital calculation is a big mistake. So many seemingly small miscalculations of working capital can lead your business into trouble.

What affects it?

In explaining it’s important I illustrated through the concept of things affecting your working capital. While there are many things that can affect your working capital there are a few relevant ones we can easily understand.

Payment cycles

Imagine buying from your suppliers on a cash basis while selling in a market that forces you to accept 30 days credit terms. If the business goes well you sell out all your stock but all your customers may choose to exercise their right to pay in 30 days and you’re left unable to fulfil new orders. This is a problem many small startup businesses have had to face and the inability of the Zimbabwean dollar to store value makes it worse.

Borrowing

The concept of a working capital loan seems simple at face value. You get money to fulfil your immediate business needs and pay it back with the proceeds. Great. However, if you have in fact borrowed working capital the cost of this working capital will eat into the proceeds. If the loan has some sort of interest rate attached (they almost always do) that affects your profitability. If you borrow money to lend to your customers (through offering credit payments) you essentially have an additional cost to consider. say you have a working capital loan that has a 10% per interest rate offering a customer credit for 30 days costs you 0.you in interest. Not much however it is coming out of your pocket. This is why businesses tend to have an escalated price for credit terms to pass on this cost.

Defaulters

One important feature of working capital calculations and most businesses is working on an accrual basis. That is, counting revenue when it is earned rather than received. When you supply me with goods or services for $1500, I owe you $1500 and will show up in your books and working capital calculations as $1500 to your credit. However, if I don’t pay on time and in fact never pay I obviously affect your working capital. Without getting too complex businesses usually institute an initial payment amount that ranges between 10 and 70% to cover themselves in the event of default. the percentage depends a lot on your business and environment.

What you can do?

First thing you can do is to learn to calculate your working capital. Writing this article for a multiplicity of business owners means we cannot delve into what specifically qualifies as working capital in your business. The simple calculation is current assets – current liabilities. An item is considered current when it is not capital or enduring in nature and expected to be used, collected or extinguished within 12 months. Keeping track of your working capital from month to month will tell a story of how your business is progressing; are you growing or shrinking? For each of the items mentioned that affect working capital, a solution has been provided that is used widely.