What’s the Difference Between Working Capital and Liquidity?
With a potential recession looming on the horizon, it’s now more important than ever to make your business’ finances a priority. A recent survey from The Financial Health Network said that only 28% of consumers in the U.S. are financially healthy. Lucky for you, you’re a savvy business owner that doesn’t fall in that statistic because you’re reading this article! Working capital and liquidity are important terms when it comes to the financial health of your business, but what exactly are they? Let’s break it down.
What is Working Capital?
Working capital essentially refers to the funds available to a company used to support its day-to-day activities. A company’s working capital measures the liquidity and overall health of the business. There are many factors that determine the amount of working capital needed by a business, such as its profitability and growth rate. To calculate how much working capital your business has at its disposal, try the calculation below.
Working Capital Formula
You can calculate the working capital of your business more easily than you might think!
Working Capital = Current Assets - Current Liabilities
Positive working capital indicates that a company can pay its short-term liabilities at any time, while negative working capital dictates that a company is unable to do so. Business analysts have suggested that working capital is commonly decreased when companies do not moderate the rate at which they pay off their bills or collect receivables. However, your company will have higher working capital when your customers pay more quickly for the goods and services offered by your business. Factoring is a great option if you highly rely on invoices from customers for your cash flow.
What influences your business working capital
The rate at which you pay your suppliers
Ability to get financing
Overall growth rate
Depending on your situation, your ability to get financing will directly affect your working capital. When viewing your company’s balance sheet, you may notice changes to your accrued expenses within the current liabilities section due to delayed payments to suppliers, which would greatly reduce your working capital available.
However, your business can have positive working capital if you have a high growth rate and are able to increase the profitability of your business. As you earn more profits each year, your working capital will exponentially increase, and that’s a great thing.
Working Capital Ratio
The working capital ratio is another way to compare a company's current assets to its current liabilities.
Working Capital Ratio = Current Assets / Current Liabilities
As you see above, a working capital ratio directly expresses the relationship between your company’s current assets and liabilities. If the working capital ratio of your company is 2.0, for example, then it can be said that your company’s assets are twice as large as the size of your current liabilities.
Here’s a tip. As you work to build the profitability of your company, be sure to not let your working capital ratio fall below 1.0, where your liabilities outweigh your assets, which can negatively impact your business.
Liquidity refers to a company's ability to pay short-term debt and expenses within a particular financial year. Liquidity is necessary for a company to continue its business operations!
The balance sheet assets of a company are always listed in order of liquidity, with the first category of current assets addressing the items that can be converted to cash to pay for current liabilities within a financial year.
What can pay off current liabilities (costs)
The liquidity of your company can be increased by positive changes to working capital and delaying the payment of current or long-term liabilities. On the other hand, liquidity is decreased when you pay your current liabilities too quickly, reduce the speed at which your current liabilities are converted to cash, or you buy too many items for your inventory at once. You can maintain positive liquidity when you balance your assets with your liabilities. It may seem tough, but if you plan and stay ahead of your business finances it’s possible!
Working Capital vs. Liquidity
Liquidity and working capital are not one in the same. Your liquidity may not necessarily be high if you have good working capital. For example, your current assets may be in slow-moving inventory. This will cause your business to lack liquidity to pay your bills on time. Another example could be if you can’t collect your accounts receivables in time to pay your employees. It’s also likely to have high liquidity but low working capital. For example, if you’re an online business that accepts debit card purchases it may force your suppliers to wait for over sixty days to receive payments for supplies, resulting in high liquidity and low working capital.
Be a Financially Savvy Superstar
Now that you know the in’s and out’s of how to calculate working capital, understand liquidity, and appreciate the difference between the two, it’s time to apply that knowledge to your business! Determine how much working capital and liquidity your business has, whether positive or negative. Once you figure that out, decide if you think it’s time to acquire more capital to grow. Working capital funding is a great way to create a safety net, hire more employees, start a new project, and so much more. Banks might not cut it, so find a working capital lender that understands small businesses like yours and the demands of your industry. Go get ‘em tiger!