Essentially, a business’s working capital is the difference between its cash (including assets that are expected to be converted to cash) and its debts (including liabilities). This is also known as current assets and current liabilities.
As such, working it out is simple. Just take your current liabilities, and subtract them from your current assets. If your business’s assets total £500,000, for instance, and your current debts and liabilities together are £300,000, then you’ll have £200,000 of working capital to use.
You can use these same figures to work out your working capital ratio, by dividing your business’ current assets by its liabilities. So, in the case of the previous example:
£500,000/£300,000 = 1.66 (working capital ratio)
This ratio is a key way of determining your business’ financial health, as it enables you to evaluate your business’ growth and capacity to cover liabilities.
A negative working capital ratio of below one means that your business is losing money as your current liabilities outweigh your current assets, and this could mean you’ll struggle to pay off any debts.
However, a high working capital ratio of above 2 means that your business has a surplus of capital that could be reinvested and therefore have the potential to increase future revenues.
There is no universal ‘perfect’ working capital ratio, and every business and industry will have a different norm or ideal. However, an indication of being on solid financial grounds is a ratio of between 1.5 and 2.
Firstly, it’s important to pay any bills on time to keep a good relationship with your suppliers. A reliable and trustworthy relationship could give you access to better prices and discounted items. And by cutting costs, you will eventually see a better capital working ratio, which means more money that can be re-invested into the business.
Secondly, revaluate your operation cycle and look to shorten it if possible. Your operation cycle begins when you purchase any raw materials and ends when you get the cash from sale of the product. The longer your operation cycle, the more money you may have tied up in it, and therefore shortening this cycle will help free up cash and improve your business’ short term capital.
Lastly, look to decrease your business’ expenses. Cut down wherever you can, whether that’s on rent, business trips, or even small things like stationary. Everything adds up, at the end of the day, and the more you can save, the greater your working capital will be.
Though you may find that your business has a high working capital ratio, with significant working capital to play with, a quick injection of cash through a working capital loan, could still be highly beneficial. For example, your business could be asset rich, but with a large amount of cash locked up in inventory stock. This will need to be converted to cash before it can be utilised to meet liabilities. Alternatively, your business might be seasonal and therefore require funds to cover any low season costs.
In these times, a working capital loan with affordable monthly payments can ensure your business can pay its bills on time and cover day-to-day costs without putting it under financial strain or causing undue stress.
Understanding and keenly monitoring your business’ working capital, as well as taking active steps to improve your working capital ratio, will keep you constantly ready to capitalise on all available opportunities for growing your business. If it’s something you’re currently unsure about, there’s no time better than the present to make a change and to get on top of your financial situation! A little work today can make a whole world of difference in the future.
At Esme, we offer business loans ranging from £10,000 to £150,000* over a 1 to 5 year repayment period. A business loan can offer you a quick injection of capital that can help your business expand in exciting directions without having to worry about major hits to your cash flow.
*From £25,500 for Sole Traders