One of the most common ways to gauge the short-term health of an organization is to measure its working capital. Working capital is crucial for maintaining operations, managing business growth, and fueling business strategies that directly impact your company’s bottom line.
Estimates of working capital, also known as net working capital (NWC), are derived from the vast array of assets and liabilities on a corporate balance sheet, such as:
- Current assets: cash, accounts receivable (customers’ unpaid bills), inventories of finished products and raw materials, and more
- Current liabilities: accounts payable, bills, and debts such as payroll, vendor payments, or rent
By calculating the difference between immediate debts and liquid assets, companies can better understand how much capital they will have in the near future. The working capital forecast usually applies to a 12-month term.
Companies can also use working capital estimates to assess their operational efficiency, current cash position, and short-term financial health. For example, positive working capital estimates can help leaders make strategic investment and expansion decisions.
However, the company may face financial trouble if current liabilities exceed the existing liquid assets, putting it in a negative working capital situation. This may be the time to take significant financial or strategic action, so the company has enough cash to cover its bills and loan payments.
It’s important not to confuse working capital and operating capital. The difference between the two is that while working capital gives you a short-term glimpse into the liquidity of a business, operating capital applies more to a long-term view. Operating capital analyzes all long-term assets versus all long-term liabilities to predict the company’s liquidity beyond the 12-month capital cycle.
The Working Capital Formula
One question many business owners ask is, what is included in working capital? Working capital can be calculated by adding up all of a company’s current assets and current liabilities. Public companies usually disclose these figures on publicly-disclosed financial/income statements. Private companies generally don’t release financial statements to the public and may not be available.
Once you have the two figures, working capital can be calculated by applying them to this formula:
In most cases, working capital is stated as a dollar figure. Let’s look at two possible scenarios where a company has used this formula to calculate its working capital:
- Company A has $100,000 in current assets and $45,000 in current liabilities. By applying the formula, we can determine that the company will have $55,000 in working capital over the short term. Company A can use this money for various projects and initiatives to help it grow. It will also have sufficient working capital to cover its short-term debts and cash left over if its current assets need to be liquidated to cover those debts.
- Company B has $100,000 in current assets but $120,000 in current liabilities. When we apply the formula, we see a working capital total of -$20,000. This means that Company B doesn’t have enough money to pay its short-term bills. Negative working capital totals signal a company’s poor short-term health, low liquidity, and the risk of missing its debt obligations. Late payment penalties and any applicable interest can make matters worse. Missing payments can also damage relationships with suppliers and financial institutions.
The 4 Main Working Capital Components
Although only two factors might be required to calculate working capital, there is much more to it when you scratch the surface. In reality, four distinct components are needed to calculate your company’s current financial health.
The four main working capital components are:
- Cash (and cash equivalents)
- Accounts receivable (AR)
- Inventory
- Accounts payable (AP)
Cash, AR, and inventory are all part of your company’s assets. Only AP belongs in the liability column.
Let’s have a closer look at each of these four working capital components.
Cash (and Cash Equivalents)
Whether it is dollar bills on hand or cash in the bank, every business must have a cash reserve to pay operating expenses when necessary. Nothing is more liquid than cash, making it a major component of your working capital.
Cash equivalents are also handy to have. These assets can be liquidated quickly without a sizable loss of value. Examples of cash equivalents include money market funds, stocks, bonds, and mutual funds.
Accounts Receivable
Another class of assets included in your working capital calculation is accounts receivable. This category refers to money owed to your company or cheques that you have received but not yet cashed. Once you’ve collected payments and deposited your cheques into the bank, the funds become sales revenue and fall into the cash category.
Examples of items that fall into the AR component of your working capital include:
- Open customer invoices
- Accrued interest on outstanding/late customer invoices
- Extended credit to other companies
Inventory
Inventory is another type of asset. It refers to tangible goods you have on hand that have not yet been sold to customers. Until the products are sold, they fall into the inventory component that counts toward assets when calculating your working capital.
Examples of inventory include products displayed in a brick-and-mortar store, stored in a warehouse awaiting sale, or in transit from your supplier. Because you’re looking to sell products quickly, these are also known as short-term assets.
Accounts Payable
Once you add up your cash, accounts receivable, and inventory, your accounts payable can be worked into the equation. AP includes all of the liabilities you expect to have over the next 12 months. Debt payments beyond 12 months are worked into your operational capital calculations.
Liabilities that are part of this key component of working capital include:
- Supplier or vendor invoices
- Short-term debt repayments on bank loans (loan principal and interest)
- Upcoming tax payments
- Unpaid dividends to investors
- Balances on business credit cards
- Wages payable to employees
- Operational expenses such as material costs and utility payments
- Leases on office, storage, warehouse, and other real estate
As a business owner, you naturally want to maximize the amount of working capital your company has available. Automated AP and AR solutions can help you achieve that by streamlining many of your accounting processes.
How Automation Can Improve Your Working Capital
Optimizing your AR processes through automation is one of the critical principles for improving your working capital and growing your cash flow. Automation will help get your invoices paid faster and significantly reduce the time your AR team spends following up on payments.
ACI’s Accounts Receivable Automation Solution for Cash Application process, AR Assistant™, improves your working capital, employee productivity, and cost reduction without requiring a significant shift in your business operations. Implementing Accounts Receivable Automation in your organization with ACI’s cloud cash application software is simple and straightforward, and will have no impact on the flow of your daily operations.
An automated solution also helps to drastically reduce the amount of paper used in your office by moving everything online and into the cloud. Paper-free offices enjoy significant cost savings on office supplies, storage, and time filing and retrieving documents.
Augment your AR automation with CheqMate™, our Remote Cheque Deposit solution. CheqMate™ allows you to have your cheque payments directed to your organization’s lockbox at our secure document and data processing facility. Here’s how it works:
- Our team receives and opens your cheque mail
- Cheques are scanned to capture the image and relevant data
- Cheques are electronically deposited directly into your account at your preferred financial institution
CheqMate™ is perfect for companies with teams that work remotely, allowing for faster, uninterrupted deposits and improved cash flow.
You can also streamline your AP processes with Ash Conversions’ AP Assistant™ solution. AP Assistant™ provides complete end-to-end AP automation that eliminates manual AP processes and reduces operational costs. It also processes invoices automatically, reducing the processing time by up to 17 days. Invoice data files are securely stored in FileManager™, our secure, cloud-based document management platform that enables real-time remote visibility into your AP system.
ACI’s Solutions Help Build Your Working Capital
Working capital helps propel your business while helping your company meet short-term needs. By consistently growing your working capital with ACI’s AR Automation Solution for Cash Application and saving money with our AP Assistant™ solution, you’ll be able to confidently deploy your long-term business growth plans for decades to come.
For over 40 years, ACI has specialized in transforming how companies run their daily business processes with efficient, cost-effective solutions, including innovative AP/AR automation that benefits both you and your customers.
As Business Process Automation specialists, our team works with you step-by-step throughout the implementation to have your solutions operational in as little as 30 days. We ensure that every question is answered and that your accounting team is proficient in operating the solutions upon implementation.
All of our systems interface easily with your ERP platform, increasing the overall efficiency of your business while making AP/AR processes operate more smoothly than ever. With ACI, you’ll be organically improving your working capital, helping you complete growth-oriented initiatives sooner.
Click below to contact us today to learn more about how ACI’s automated solutions can help take your business into the future.
