Startup businesses are challenging enterprises for anyone who runs or owns one. Being new in the market usually means that you cannot predict the impact of your decisions. Most things are just trial and error. However, you can change the narrative by learning about the fundamental aspects that affect the decisions you make for your business. Examples here include accounting essentials such as income statements, balance sheets and cash flow statements. In this blog, the focus is on working capital. Read on to understand the element of working capital and the impact it has on your business.
The Meaning of Working Capital
Any startup business has long-term and short-term assets. Long-term assets are the physical resources you have that you expect to use for more than one financial period. Examples include land and machinery. The short-term assets include the resources you use and replace within a short period. It could be daily, weekly or monthly. They include items in stock, amounts payable by debtors and cash.
On the same note, the business has long-term and short-term liabilities. Long-term liabilities extend beyond one financial period and a good example is a long-term loan borrowed to finance the business. Short-term liabilities are the obligations you need to meet within a year such as monthly taxes and amounts payable to suppliers.
Working Capital: What It Represents
Working capital measures your operational efficiency and liquidity. In this context, operational efficiency means that your business achieves targets you set in the short term. For example, your ability to pay suppliers on or before invoice due dates without straining the business financially points to operational efficiency.
Liquidity is another important metric in working capital. Liquidity is the ability of your business to generate cash or turn inventory into cash, enabling you to meet your obligations. You will run into financial problems if you tie too much cash up in stock that you cannot convert into cash.
An Important Takeaway on Working Capital
If you want to calculate your working capital, take the sum of your current assets and divide by the total of your current liabilities. A negative result, meaning that the ratio is less than one, indicates that you are not generating cash fast enough to meet your obligations. A positive ratio, which is greater than one, shows that you can sustain your operations and expand by taking advantage of future opportunities. However, note that having a high positive ratio also means that you are not investing your excess cash.
To learn more, contact an accountant.