Boost your business health: Learn how to optimize your working capital

Running a business takes work. One of the most critical financial aspects of running a business is CASH FLOW. Something I hear a lot from business owners and experts is: “cash flow is the leading cause of business failure.” However, I would argue cash flow issues are the result of deeper management issues, rather than the cause of them. One of the best things you can do for your business to keep up with cash flow is to understand and forecast your working capital.

Current Assets - Short Term Liabilities = Working Capital.

Working Capital is typically looked at after the end of a period (month, quarter, year). It is the difference between current assets (Cash, accounts receivable or what your customers owe you, inventory) and short-term liabilities (debts owed within 12 months, accounts payable or what you owe to your vendors).  It measures your company's ability to pay off current vendors, recurring bills, and any debts due within 12 months. It is an indicator of financial health. 

What we’re focused on today is forward-looking working capital. 

This answers the question: how much cash does it take to run my business for a month?

Put another way - what’s the amount of cash needed to fill the gap between revenue coming in, and bills going out?

Let’s review before we move on. 

Working capital is the amount of cash you need to fill the gap between when cash comes (income) and when cash goes out (costs/expenses). 

Why is it important? 

• If you look at your business only once a year, you’ll see revenue (sales or income), Expenses (costs, COGS, operating expenses),  and net income (revenue - expenses).  If you're doing well, you’ll see that net income is a positive number. Meaning you brought in more money (revenue) than you spent (expenses).

• If you break down your business by the day - you’ll notice that sometimes you don’t make more revenue than expenses on a given day, and in others, you may make a lot more revenue than you spend.

• When you understand your working capital - you can cover any gaps where you might be spending more than you currently have.

When to use this number: 

• Business planning: when building a business plan, account for this number in addition to start-up costs.

• Check on it regularly: 

  • Every month or quarter, review your balance sheet and calculate your working capital ACTUALS by taking your current assets and subtracting your current liabilities.

  • Review your FORECASTED or PLANNED working capital every month or quarter by following the flow.

  • Compare the two numbers and make sure you’re maintaining what you need to make for your current business structure and future plans. 

What to do if you have too much working capital: 

• Put the extra into your cash reserve account

• Use the extra funds for sales & marketing, people, software, equipment, systems, or software that will drive more revenue 

What to do if you’re not holding enough: 

• Build up a cash balance: don’t spend all your income on expenses; build up cash to meet your working capital number before continuing to spend and invest in business growth

• Negotiate better accounts receivable terms with existing customers

• Add a new revenue stream where payments are due on receipt

• Extend your accounts payable terms with vendors where possible

Things to keep in mind: 

• Working capital is not the same as cash reserves

• Cash reserves are the amount of money a company has set aside (best if kept in a separate account). These funds should be kept for unexpected expenses or to take advantage of new opportunities (i.e., equipment upgrades). These shouldn’t be part of your working capital calculation. 

• Payroll isn’t included in the working capital calculation above. This can get confusing because it is logical that you would keep it there. There are more accurate ways of forecasting working capital that include bad debt (unpaid invoices) and payroll. The other way to add is to always hold 1-2 months of payroll on hand in a reserve account. Both the analysis and the reserves are worth doing eventually; for now, though - keep it simple. 

Forecasting your working capital can prevent your business financials from getting out of control. It’s a key component of good cash flow management. Following this method is a simple way to get started understanding working capital and reviewing it regularly.

Financially healthy businesses flourish - be one of those!

Okay, but what now?

Get the working capital worksheet here: WORKING CAPITAL WORKSHEET 

Here's my ask - if you use my worksheet, share, love it, hate it, please email me and let me know what you think. hello@financefightclub.com

what’s the amount of cash needed to fill the gap between revenue coming in, and bills going out?

Get the working capital worksheet here: WORKING CAPITAL WORKSHEET