Working Capital Is Paramount To A Businesses Livelihood
It’s the lifeblood of a business – the money it needs to purchase materials, pay employees, and run its operations. Without it, businesses can’t get by. Even when they’re profitable, they won’t be successful if they don't have enough working capital to grow. To understand what working capital is and how to measure it, read on!
Today we are going over an aspect of a business that is paramount to every company but often overlooked until there is an issue: Working Capital. Most business owners would rather use their profits to pay debt and taxes instead of doing what needs to be done, which is reinvesting in their business. In this article I will teach you how to analyze your working capital and how to create a plan for what you will invest this capital back into your business.
The first thing that you want to do is determine the Liquidity Ratios of your company because liquidity ratios are going to tell you the types of cash flows your business generates and the financial strength it has. You can then use the ratios below to get a better understanding of where this particular money is coming from and where it is going.
Working Capital Ratio:
Working Capital is calculated by dividing current assets by current liabilities, which makes it a liquidity ratio. The two most important things to look for when analyzing working capital are 1. Total Current Assets and 2. Total Current Liabilities. Total Current Assets are a combination of Cash & Cash Equivalents + Short Term Investments + Accounts Receivable + Inventory - Accounts Payable & Loans from Banks or Credit Unions. Total Current liabilities include accounts payables owed for goods sold and other short term debts but not pensions, taxes or depreciation (although all of these are listed below as non-current liabilities) . You want the ratio to be above 1.
Total Assets Over Total Liabilities:
This is the most simplistic way to see if your business is profitable or not. If it is under .9 then you need to do some evaluating of assets and liabilities and see which side needs help. Then you can go back to the working capital ratio and see what kind of changes are in order by looking at your current assets and current liabilities.
Inventory Turnover Ratio:
The inventory turnover ratio shows us how many times it takes an average company to sell its inventory during a year. It’s calculated by using the units sold divided by ending inventory (or beginning inventory + ending inventory). If it’s below 1.1 then it means your business is losing money because you are overspending on the inventory that you already have. This measuring tool will give you the best indicator of whether or not you need to sell your product before purchasing more and whether or not your product is being sold at a proper rate whether it’s in retail, wholesale, or both.
Interest Coverage Ratio:
This ratio measures how much each dollar of current assets are able to cover in interest expense. It tells us if we need to be changing our working capital ratios by looking for ways to reduce capital expenditures so that we can pay off more debts. This ratio is calculated by using the EBIT (Earnings Before Interest and Taxes) divided by the interest expense. If it’s below 1 then you need to find a way to reduce your interest expense or increase your earnings before interest.
Total Liabilities over Total Capital:
This ratio tells us how capable your business is at paying off its liabilities with its assets. If it’s less than .9 then you need to start making some changes if possible in order to pay off any debt that you may have and be able to pay yourself back for anything that you have invested in this company since you will want to see your money grow as well.
This article is a great resource for you to get started in understanding your working capital and how valuable it can be when analyzing your company. For more information on working capital, make sure to read this article about how to effectively use a ratio analysis for great results in your business.
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