Written by Craig Evans
Posted on 19/08/2016

Why a working capital focus is crucial for your business

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Whether you’re a business owner, credit manager or finance director, the task of effective working capital management ought to be a key concern. Why? Because it’ll ensure your business has the cash it needs to operate while demonstrating the strength of your management.

So what is working capital?

Working capital is an indication of a company’s short-term financial health, measured by subtracting its current liabilities from its current assets. As the name suggests, it is the capital a business has access to in order to ‘work’ – i.e. to meet its everyday financial obligations and operational costs.

Why does working capital matter?

Working capital matters because it signifies a company’s liquidity, efficiency and short-term prospects. Not only does it give businesses and investors the confidence to work with that company based on its financial health, working capital also reflects the company’s management strength.

Working capital ratio

As businesses come in all different shapes and sizes, and the working capital of a FTSE 100 will be vastly different to that of a start-up. The working capital ratio was developed as a way to evaluate companies’ working capital.

It is calculated as current assets divided by current liabilities. A ratio between 1.2 and 2 is considered good, while anything below 1 equates to negative working capital. On the other hand, while a score above 2 may seem positive, it can be an indication of poor managerial strategy as it shows that a company is not reinvesting its surplus cash.

To make matters more confusing, an increase in working capital can be caused when a company’s money is too tied up in inventory or the company is failing to collect customer payments efficiently. This is because current assets include the accounts receivable ledger (expected payment for completed sales) as well as the company’s inventory.

As a business, finance or credit manager, your challenge is to achieve the right balance between reinvesting in your company to promote growth while remaining liquid enough to meet short-term financial obligations.

The importance of working capital

Effective working capital management keeps your business running and in good health and improves your ability to borrow, increases your share price (if you’re a listed company) and attracts other businesses and investors. It’s the central mechanism for balancing profitability, growth and liquidity.

Changing business practices

Recent research by business consultancy REL examined the working capital practices of the top 1,000 businesses within Europe. The results showed that most had improved their efficient use of working capital in 2015.

Improving working capital can be a quick way to release cash. REL’s research indicates that working capital remains a key priority in today’s tempestuous economic environment and that cash, in particular, remains a core strategic focus.

Although the need for working capital differs by industry and business size, effective working capital management is still a fundamental feature of good business practice. You can read more about how to improve your working capital with our quick tips.