Working Capital 101: The Small Business Owner's Guide

What the Heck is Working Capital?

You're probably sick of hearing about working capital.

Every business has working capital and next to cash, working capital is the lifeblood of every business. (If you think you don't have working capital in your business, please send me a note, I want to hear about it!).

First, what is working capital?

Here's a Net Working Capital (NWC) cheat sheet highlighting:

1. Definition of working capital (receivables plus inventory minus payables);
2. How an increase in each of those items will affect your cash balance; and
3. The related P&L account for each component of working capital (i.e. when you sell something on credit you're increasing A/R).

Why should this matter to you?

If your business were a machine, then working capital would be the lubricant between profit and cash. It both consumes and creates cash to cover your day-to-day operating expenses.

The crux of it comes down to survival... working capital puts companies out of business. That's right, you can have all the profit in the world, but if you've overinvested in working capital you'll run out of money in a hurry (if your business is losing money AND overinvesting in working capital, you're toast).

On the other hand, if you don't have enough working capital, then you might lose out on potential sales from lack of in-stock inventory or not extending enough credit to customers (A/R).

So how do you manage this thing??

Fortunately we have ratios to help us here (plug: Profit Mastery goes deep into ratios and benchmarking!)

1. Turnover ratios
2. Days on hand
3. Percentage of assets or revenue

It would take a much longer post to dive into each of these metrics so we'll save that for another day (or class session!).

The main takeaway is: calculate these metrics (whether monthly, quarterly, or yearly), plot them over time, and track them against your industry. We posted a metric cheat sheet on LinkedIn a while back, it's a useful starting point:

Homework

This week's assignment – Try calculating receivables or inventory turnover for your business. Just take your last 12 months worth of sales or COGS and divide by receivables or inventory, respectively. Now you've taken one step closer to managing working capital!

P.S. if those ratios are below 1.0 – I would consider that the "danger zone," give us a call or send an email and let's talk through it.