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How strong a company’s finances are can be gauged from the balance sheet, which in turn is assessed on the strength of the company’s working capital, from among several other factors. Even then, it is among the concepts that can be difficult to define for a small business or a startup. This is because working capital is the difference between current assets and current liabilities. Current here applies to assets that are convertible to cash within a period of 12 months or less and liabilities that are due for clearing or payment within the same period.
Working capital then becomes fairly easy, but it is not so for a small business or a startup that may not have much, to begin with in the first place. How should you calculate the working capital, then? One way is by looking at the operating cycle.
The operating cycle typically analyzes accounts receivable by the number of days it takes to collect while accounts payable is calculated in terms of the number of days it takes to pay off a vendor invoice. Inventory, which is also part of an operating cycle, is analyzed in terms of the number of days taken by a product to convert to cash or account receivable (resulting from a sale).
How is working capital analyzed?
When a business has more current liabilities than current assets, it can have trouble in making its payments. Over a period of time if this does not change to more current assets, the business could head into bankruptcy. Working capital sometimes also goes into decline over the long term. When this happens, it could indicate slowing down of business in other ways like reducing sales volumes, or other operational reasons.
Inefficient operations can result in reduced collections and increase in working capital, as a result.
Why optimize and ways in which to optimize it
Optimizing the working capital is important because it is one of the major ways in which cash is available to a company.
Here are some of the ways in which you can optimize the working capital of your company:
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