Entrepreneurs and managers of a company need to understand and monitor various indicators and metrics in the business. Therefore, knowing what working capital is, how it works and the need for this resource is essential for good management.
After all, working capital helps maintain your company’s activities and avoid debt. Therefore, routine calculation and monitoring help the company to have greater financial health and profitability.
Want to learn what working capital is, when it is needed and how to calculate it? Continue reading this article and find out more!
What is working capital?
Working capital is an indicator of business that represents the financial availability to cover the company’s operating costs. In this way, the amount can be treated as a reserve of a company’s finances.
Working capital settles actual costs: utility bills, rent, employee wages, suppliers, etc. This is the volume of financial reserves necessary to pay for the cost of business activities of the company.
A common confusion often occurs between the working capital of the business and the profits it earns. Nonetheless, they are two very distinct measures. Profit is what a company makes for a given period after deducting all the expenses paid.
In other words, profit is what’s left over after paying off obligations. Working capital needs to be there in the business well before it turns profitable. After all, it needs a financial reserve to start operations and make payments, right?
What is working capital for?
Let’s take a concrete example of the indicator to get a better sense of what working capital is for. Suppose, for example, that your company has R$20,000 in accounts payable during a particular month.
This would mean, during this time, the firm needs to possess at least R$20,000 in liquid assets, wouldn’t it? The best time for a profitable event to arise isn’t exactly when sales occur on the products or service agreements come into fruition.
After all, they may not be enough and your company will be vulnerable. Therefore, working capital serves to guarantee the payment of obligations — such as payments to suppliers, payroll expenses, real estate costs, among others.
The main benefit of having sufficient working capital is to ensure that all of the business’s operating expenses are paid without third-party resources. With it, it will not be necessary to resort to loans or other lines of credit, which bring more costs to the business.
Using these solutions can lead to more financial problems if they are not properly studied. After all, obtaining credit is a common situation in companies, but allowing this need to be recurrent can be a warning sign of operational and financial setbacks.
When is working capital necessary and how is it calculated?
As you have noticed, working capital is an essential financial reserve for maintaining the company’s activities. So you must know how to calculate the need for this amount in the period evaluated.
It is also common practice for managers to look at only short-term liabilities, which are payments that need to be made in the very near term. But the study of working capital needs ought to be more holistic, providing a more wholesome view of the business situation.
In this context, the calculation can follow two methodologies. Check out how they work below:
Difference between current assets and current liabilities
One way to check the working capital situation and, consequently, its need, is by calculating the CGL. The acronym stands for net working capital and represents the difference between current assets and current liabilities.
Current assets refer to all of the company’s capital reserves, assets or rights that can be converted into cash in the short term. As such, they are the business’s highly liquid resources.
Some of the most common examples include:
- cash in hand;
- short-term investments;
- accounts receivable within 12 months;
- stock;
- raw material.
Current liabilities are payments that must be made in the short term. This category includes any debt that is due within 12 months and must be paid off by the company. Some examples are:
- payment of employees ;
- service accounts;
- debts with suppliers;
- installments of loans and financing.
To calculate the CGL with these metrics, simply follow the following formula:
CGL = current assets – current liabilities
If the result is positive, it means that you can pay your bills and still have some left over. In other words, there is no need for more working capital during this period. On the other hand, a negative number means that you need to obtain resources to pay off your financial obligations.
Difference between receipt and payment terms
Another way to check the need for working capital is based on the company’s receipt and payment terms. To do this, it is necessary to find two indicators relating to the average term.
The first is the average collection period. This corresponds to how long, on average, debtors will take to pay their bills — as in the case of installment purchases and credit payments.
The average payment term refers to the average period within which the company must pay off its debts. To determine these two indicators, it is possible to consider the specific periods in which you want to evaluate working capital.
Once you find these averages, apply the following formula:
average receipt times – average payment times
If the result is a positive number, this means that there is a need for working capital, given that the bills will be due before the company’s payment deadline.
On the other hand, a negative number indicates that receipts will occur before payments, so the company has the capacity to settle its obligations.
Have you understood what working capital is, how it works and how to determine the need for resources? By knowing this indicator and monitoring it regularly in the company, it is easier to avoid financial problems and optimize management.