What is “short-term”?
The “short-term” period refers to the operating cycle of a business. This is the amount of time a company needs to convert its initial investment (outflows) in raw materials into sales (investments plus profits). For example, a manufacturer will need to buy raw materials (merchandise in case of a trader), spend money to convert them into finished goods and arrange for warehousing.
If you raise the required funds from outside, they become current liabilities. Most commonly, they are in the nature of short-term borrowings from banks, individuals or other entities. The next step is to sell the finished products to generate income. Cash and cash convertibles, such as inventories, finished goods and accounts receivable (debtors), form the current assets. This is also known as gross working capital.
See Also: Estimating Working Capital Requirement
What is “net working capital”?
Net working capital is the difference between your total current assets and total current liabilities. It is realistic and the most commonly used version. At a given point in time, it indicates the actual amount of cash and cash convertibles available after meeting the outside obligations. A positive number means you are able to pay off your short-term obligations, while a negative working capital is not good news.
Working capital can also be expressed as current ratio (current assets/current liabilities). If the ratio is less than 1, you have negative working capital. This means your business will face challenges in covering the short term or instant obligations. On the other hand, if the working capital ratio is very high illiquid assets are reducing your profitability. This may imply that the stock is too high or that you have idle bank balances that you should have reinvested into the business.
How to analyze working capital?
Though working capital is an important financial indicator for any business, it cannot provide you with meaningful information in isolation. For example, a current ratio of less than 1 is almost always a red flag, but there is no ideal positive ratio that fits every situation. It depends upon the industry, stage of the business, region and the state of the economy.
On the other hand, the analysis of each individual component of current assets/liabilities is equally important and this is where quick and super-quick ratios come in. A business must manage each of these elements effectively. In the case of receivables, for example, make sure your customers understand your payment conditions and that you follow up with them when they don’t pay on time. If you have customers who continuously miss the payment deadlines, you can ask for an advance deposit, or thee full amount up front or cash on delivery. If you do not manage your receivables well, it could have a negative impact on your cashflows. At the same time, you must avoid excessively stringent conditions that may drive your customers away.
Eurion Constellation has been helping businesses in developing a thorough understanding of these elements to create and readjust the cash, inventory and payables/receivables policies for maximum efficiency. Firm up your finances, get in touch at firstname.lastname@example.org. WhatsApp us at +919654421064. Eurion Constellation serves businesses in the U.S, Europe, and India. We will be extending to other regions soon.