One of the most important tools in keeping business operations running smoothly is working capital. Working capital is the capital used in day-to-day operations of a business. It’s calculated as subtracting current liabilities from current assets. In this article, we’ll explore the importance of maintaining sufficient working capital and provide a brief discussion of the nuances of working capital vs. revenue.

Why maintaining sufficient working capital is essential

Proper management of working capital is essential to a company’s operational success and financial health. Working capital can be used for many things, but is used primarily for boosting growth, maintaining liquidity, and increasing profitability. Working capital is required for a business to carry out routine tasks such as making payments, covering unexpected costs, and purchasing materials for the production of goods. 

When you don't have sufficient working capital

When a business begins to be short on working capital, maintaining basic business operations becomes more difficult. Additionally, insufficient working capital can lead to material and delivery inefficiencies that can hurt supplier and customer relationships. In order to maintain the appropriate amount of working capital, the business will need to manage inventory, accounts payable, and accounts receivable. The goal is to create and maintain sufficient cash flow to fund a company’s operations in the short-term.

 How can I measure my working capital?

Now that you know the importance of maintaining sufficient working capital, it is important to ask yourself the following question: “How can I measure the management of my business’s working capital in a quick and efficient way?”  Many business owners understand the vitality of maintaining sufficient levels of working capital, but fail to regularly track it.  This is a significant mistake as lack of working capital is one of the primary reasons that small businesses permanently close their doors.

Perhaps the easiest way to track the management of a company’s working capital is the “working capital ratio”.  Also known as the “current ratio”, this ratio helps business owners determine if they have adequate cash flow to cover short-term debts and expenses.  The working capital ratio is calculated by dividing current assets by current liabilities.  Any result greater than 1 is typically viewed as positive – though interpretations of this ratio vary by industry.

Hopefully, the importance of maintaining sufficient levels of working capital is clear.  This metric is perhaps the most important in measuring the viability of short-term operations.  Companies may consider consulting with industry specialists in understanding appropriate amounts of working capital to keep on hand.  Regardless of industry or business model, this much is clear:  businesses should begin to regularly calculate and track this essential indicator.

Working Capital vs. Revenue

Revenue is defined as “money generated from normal business operations, calculated as the sale price times the number of units sold”.  Basically, the term “revenue” refers to the top line income on a company’s income statement.  Revenue is an essential metric and a key indicator measured by all companies.  Because of the importance of both revenue and working capital in the day-to-day operations of a business, it is essential to understand the differences between the two.

The difference between working capital and revenue can be a difficult thing for business owners to wrap their heads around.  However, it is important to understand that revenue can only be recognized when a company has actually fulfilled the obligation required by the customer.  In other words, a customer may order a pair of shoes online from a shoe retailer, but revenue can only be recognized by the shoe retailer when they have shipped the shoes.  Because of this distinction, large chunks of revenue may be recognized in a period after the sale has actually occurred.

Working capital + accrual accounting

An additional layer of complexity is added for companies accounting for revenue on an accrual basis.  These companies are bound by the same rules related to revenue recognition.  However, these companies will recognize revenue immediately following the fulfillment of their obligation – regardless of cash flow.  This is an important distinction because recognizing revenue prior to the collection of cash results in the creation of accounts receivable.  Although accounts receivable is a current asset (and is therefore used in the working capital ratio), it often requires time and energy to collect on.  Additionally, customers may not be able to make good on outstanding accounts receivable.  These are important factors to remember when determining how much working capital is necessary for business activities.

A basic understanding of how revenue and cash flow interact is essential to determining the appropriate level of working capital required to maintain stable business operations.  Revenue is necessary to create and maintain working capital.  However, revenue is not working capital.  Rather, working capital is required to generate revenue by the providing of goods and services, pay suppliers, and collect on outstanding accounts receivable.  Business owners should make sure that they understand and are tracking both important metrics.