Monday, September 26, 2022
Cash FlowUnderstanding your Business Financials – Working Capital – Part...

Understanding your Business Financials – Working Capital – Part 1


This is the first in a series of articles that will better help you understand your company’s financial statements, both as they relate to your day to day business, and how to interpret the statements that your accountant or CPA is preparing for you. Cash is king and we will examine it first from the perspective of “working capital.” By definition, working capital is:

Working Capital = Current Assets – Current Liabilities

As the term “current” applies, this is a measure of the short-term financial health of your business, as well as an indicator of operational efficiency. Let’s start with current assets. On your financial statements they should be listed in order of liquidity, hence why you will usually see “cash” at the top.

  • Cash.
  • Cash Equivalents.
  • Short-term Deposits.
  • Marketable Securities.
  • Accounts Receivable.
  • Work in Progress.
  • Raw Materials.
  • Finished Goods / Inventory.

These are items you are familiar with and can be converted to cash in the near term. The amount of current assets one should maintain will be covered momentarily. Let’s look at current liabilities.

  • Accounts payable.
  • Sales taxes payable.
  • Payroll taxes payable.
  • Income taxes payable.
  • Interest payable.
  • Bank account overdrafts.
  • Accrued expenses.
  • Customer deposits.

Again, items that are owed or payable in the near term will be considered current liabilities. Longer term liabilities would be items such as semi-annual coupon payments on long term financing bonds.

In order to maintain proper balance, you want your current assets (numerator) to be greater than your current liabilities (denominator). Working capital is analyzed as a ratio known as the current ratio. This is current assets divided by current liabilities. Although this is a simple and basic measure, it holds amazing import to the liquidity of your business. A current ratio of 1.2 to 1 or 2 to 1 is considered normal. Again, this will vary by industry. When your assets fall below your liabilities your ratio will be less than one, meaning you are not able to cover your short term costs. This is a major red flag. On the other hand, a ratio above 2.0 might indicate that a company is not using its excess assets effectively to generate maximum possible revenue. A better problem to have.

If the red flag is being waived by the current ratio, we can drill deeper and look at what it takes to stay afloat by using the quick ratio. As our numerator we are only using cash and cash equivalents to see if how we meet our current liabilities. This is used because not everything is immediately convertible to cash, so it can’t be used tomorrow, so to speak, to pay an account due.

Working capital can be managed on the asset side by increasing sales and the accounts receivable associated with them. Work on accounts that are slow to pay, as this can hinder your current ratio. Working capital is a component of your companies “cash flow.” Now that we have a handle on what working capital is and how to measure it, we can advance to cash flow, which is simple in concept, the net amount of cash flowing in and out of your business, but it speaks at the most fundamental level to a company’s ability to create value for shareholders.

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