Why working capital matters to your business (2024)

FAQs

Why working capital matters to your business? ›

Having sufficient working capital provides a safety net to help the business through the slow months until cash flow picks up again. It can also help you take advantage of new opportunities – allowing you to upgrade equipment or ramp up production to fulfil a new contract, or to take on a job with long payment terms.

Working capital is used to fund operations and meet short-term obligations. If a company has enough working capital, it can continue to pay its employees and suppliers and meet other obligations, such as interest payments and taxes, even if it runs into cash flow challenges.

Working capital is a daily necessity for businesses, as they require a regular amount of cash to make routine payments, cover unexpected costs, and purchase basic materials used in the production of goods.

While profit can seem to be the most important number in your financial statements, working capital makes sure your company will continue operating because it's necessary to pay off current liabilities, seize growth opportunities, and protect your organization against risk.

Most businesses use capital as a way to grow. Capital helps a company grow by providing the assets it needs to generate more revenue. A company that expands physically, adds new technologies or relocates might need additional cash to purchase new facilities or hire new personnel.

Working capital is a measure of a company's short-term liquidity and is calculated by subtracting current liabilities from current assets. In simpler terms, it is the money a business has available to fund its day-to-day operations.

Liquidity issues: If a company has negative working capital, it may not have enough cash on hand to cover its immediate expenses. This can lead to cash flow problems, which can make it difficult to pay suppliers, employees, or other expenses.

Regular working capital: This is the least amount of capital required to meet current working expenses under normal conditions. Some examples of this capital include salary and wage payments, materials and supplies, and overhead costs.

While the definition of a good current ratio can vary, generally speaking, between 1.5 and 2.0 is a good ratio to aim for. A current ratio between 1.5 and 2.0 typically shows that you have enough working capital available while using your assets efficiently.

Working capital management aims at more efficient use of a company's resources by monitoring and optimizing the use of current assets and liabilities. The goal is to maintain sufficient cash flow to meet its short-term operating costs and short-term debt obligations while maximizing its profitability.

Why working capital is important to prevent business failure? ›

A strong working capital position can also protect a business from the unexpected. When the going gets tough, cash is king and the ability to cover short-term expenses, even when facing unforeseen obstacles can help a business to avoid more significant financial difficulty and ultimately, falling over.

The most crucial benefit of working capital is that it assists a company in running its business effectively. For instance, working capital is necessary to pay employee salaries, pay suppliers for raw materials, and pay regular administrative expenses on time. Without it, business operations are usually impossible.

If a business does not have enough working capital, it may struggle to pay its short-term debts and operational expenses, such as salaries, rent, and utility bills. This could lead to operational difficulties and disruptions, which could harm the company's reputation and relationships with suppliers and customers.

Adequate working capital allows businesses to manage operations smoothly, invest in growth opportunities, and handle unexpected expenses. Moreover, it reflects the business's financial health, enhancing creditworthiness and making it easier to secure loans and favourable credit terms.

Liquidity Management:Adequate working capital enables a company to meet its immediate financial obligations, including paying suppliers, salaries, and utility bills. This liquidity management is vital for business continuity.

Working capital affects both the liquidity as well as profitability of a business. As the amount of working capital increases, the liquidity of the business increases. However, since current assets offer low return, with the increase in working capital the profitability of the business falls.