Working capital: survival and profitability

Working capital is a simple measure of a company's ability to meet its short-term operating needs. When positive, it confirms that the business has sufficient cash to service its short-term debt, paying each payment as it falls due.

It is a indicator of the short and medium-term financial health of a company, and is therefore a metric that must be monitored to ensure the survival of the business. It may also indicate the ability to support growth without recourse to borrowing or other capital raising.

How is the working capital calculated?

In order to calculate the working capital, it is necessary to be clear how much current liabilities amount to:

• Immediate/short-term debt.
• Accounts payable.
• Salary, inventory and supplies.

This is subtracted from current assets, which are liquid assets such as cash, accounts receivable and inventory.

What is positive working capital?

Positive working capital is a reflection of a company that can meet its short-term debt obligations.. However, three points need to be made:

1. This is not always a beneficial magnitude for the business. In fact, if there is a large surplus of working capital (i.e. current assets are more than twice the amount of current liabilities), this means that the company is not efficient in converting assets into income.
2. Conversely, if the working capital, although positive, is too low, then the company may run into financial difficulties.
3. A decline in working capital over a long period of time, even if not negative, can also be an indicator that the company is facing problems., The main reasons for this are, for example, declining sales, inefficient management or even unsustainable growth, which would ultimately affect cash flow.

Working capital needs to be assessed on a case-by-case basis, depending on the nature of the industry. For example, businesses that are seasonal (e.g. tourism and hospitality at beach locations or ski equipment rental) will require a larger working capital to stay afloat during the low season, which is not the case for businesses where there is not as much difference in turnover throughout the year.

What is negative working capital?

Negative working capital is a reflection of a company's accounting where current liabilities exceed current assets..

This situation implies a business risk, The EU may not be able to meet its obligations in the short term. It may also be unable to meet its short-term obligations, Extended periods of negative working capital can lead to bankruptcy and insolvency.

How to boost business profitability with working capital?

The ability to reduce the terms of outstanding receivables and extend the days payable without incurring fees or interest is the key to making money with the working capital fund.

The combination frees up cash, providing multiple lines of free short-term credit. This type of strategy reduces net interest expenses and results in a direct increase in profitability.

Working capital can also become a source of short-term financing. to help with various investments and take advantage of opportunities that would otherwise be out of reach for the business. For example, improvements in inventory management can also improve managers' confidence in inventory, thereby eliminating inefficiencies and mitigating the risk of inventory obsolescence.

However, although the working capital provides a fairly accurate picture of the company's health, it can sometimes be misleading and you have to know when. For example, positive working capital is good, but not if it is due to high receivables or inventory. In these cases, or when in doubt, it is worth complementing the analysis of the company's finances with a study of the cash conversion cycle.