Working Capital: What is it and why is it important?

Working capital It is a fundamental concept for the financial health of any company. 

It represents the difference between cash on hand and outstanding obligations. We will explore what it is, how to calculate it, and why it is so relevant. 

What is working capital?

He working capital It is the amount necessary for a company to maintain its operations on a regular basis. 

Includes all essential financial resources to cover costs and expenses over time. 

When starting a business, calculating working capital is crucial to determining how much cash must be held to meet all obligations according to the business plan.

However, this indicator is not only relevant at the start. Working capital remains an essential tool for financial control and ongoing evaluation of the company. 

It shows how much cash the company has in liquid assets (goods and rights that can be quickly converted into money) to pay its short-term obligations, such as suppliers, taxes and salaries.

Difference between Share Capital and Working Capital

When starting a business, two crucial financial concepts are interconnected: equity capital and working capital. 

Although their names sound similar, each one assumes a different role in the financial life of their company. 

Social capital: the founding basis

Share Capital is the backbone of your company, representing the total amount contributed by partners or shareholders. 

This amount may be in the form of money, property or property rights, and is used to finance the start-up of operations, including:

• Acquisition of assets: Equipment, machinery, furniture, vehicles, etc.
• Opening costs: Legal fees, licenses, permits, etc.
• Pre-operating expenses: Market research, product development, initial marketing, etc.

+ Human Resources Consulting: What is it and what are its main advantages?

Working capital: daily fuel

Unlike Share Capital, which establishes the foundation of the company, Working Capital acts as the engine that drives daily operations. 

It is defined as the difference between current assets (available in the short term) and current liabilities (short-term obligations).

Working Capital allows you to:

• Comply with your suppliers: Ensuring the continuous flow of supplies and materials.
• Cover operating costs: salaries, rent, utilities, etc.
• Finance short-term growth: expanding inventory, increasing production, etc.

Illustrative analogy:

To better understand the difference, imagine your business as a house:

Share Capital: This would be the initial investment in land, construction and basic materials.

Working Capital: This would be the money needed to pay for electricity, water, buy food and other daily expenses to keep the house running.

Importance of a clear understanding:

Distinguishing between equity capital and working capital is crucial to planning your finances, as you can better assess short- and long-term investment and working capital needs.

In addition, it is important to make strategic decisions, for example, to select sustainable growth options and avoid excessive debt.

It is also essential to mention that by distinguishing you will be able to analyze the financial health of your business, to measure the efficiency and solidity of your company.

+ Qualities of a leader: 12 attributes that everyone should have

How to calculate?

To determine or Capital for your company, you will need:

• Updated balance sheet: provides an overview of your assets and liabilities.
• Updated management control: monitor company results in real time.

With these tools in hand, you can apply the basic formula:

Net Working Capital = Current Assets - Current Liabilities

Digging deeper into the components:

Current Assets: It involves short-term assets (less than 1 year) such as:

• Cash and banks: money available in current and cash accounts.
• Accounts Receivable: values that customers owe you for products or services.
• Inventory: ready-to-sell products, raw materials and products in the production process.
• Temporary investments: short-term financial applications.

Current Liabilities: covers short-term obligations (less than 1 year) such as:

• Accounts payable: amounts you owe to suppliers for products or services.
• Loans: short-term financing obtained from banks or other institutions.
• Taxes: tax obligations payable to the government.

Practical example:

Let's say your company has:

• Current Assets: $100,000 MXN
• Current Liabilities: $80,000 MXN

Applying the formula, the Net Working Capital would be:

Net Working Capital = $100,000 MXN - $80,000 MXN = $20,000 MXN

Interpretation of the result:

• Positive Working Capital ($20,000 MXN in this example): Indicates that the company has sufficient resources to finance its short-term operations.
• Negative Working Capital: It indicates that the company may have difficulties in meeting its short-term obligations, requiring measures to increase capital.

Calculation improvement:

For further analysis, you can calculate the Liquid Working Capital and the Working Capital Index:

• Liquid Working Capital: Current Assets - Current Liabilities - Inventory
• Working Capital Ratio: Liquid Working Capital / Current Assets

+ Credit for your NAFIN business: discover the main options

How to improve working capital in your business

This capital is a crucial indicator of the financial health of any company.

There are some effective strategies that can improve and optimize this feature.

First, you need to speed up your invoice collection cycle. To do this, you can take steps such as:

• Establish clear payment policies for your customers.
• Quickly process and send electronic invoices (CFDI).
• Actively track payments.
• Consider offering discounts for paying in advance.

Another important step to take if you need to improve your working capital is to negotiate deadlines with suppliers.

That is, look for agreements that allow you to extend payment terms to suppliers.

This action will give you more time to convert your inventories into sales before paying suppliers.

The third strategy involves inventory optimization and management; it is very important to control and reduce stock levels.

In other words, avoid having excess stock, as this ties up capital.

In addition, to improve this management, use efficient inventory systems.

Improve your accounts receivable as well. Evaluate the credit policies you offer your clients.

Additionally, it is important to proactively monitor accounts receivable. Also, consider options such as factoring to obtain immediate liquidity.

It is also important to control and reduce your outstanding bills. To do this, you can negotiate deadlines with your suppliers to align them with your billing.

Make sure you pay your bills on time to avoid penalties.

Finally, the last strategy to improve your business capital is to use technological tools.

With these tools you can automate processes to streamline financial management.

To step up your efforts, make sure you implement monitoring and control systems in your business.

A working capital plan will help you protect your business against unforeseen events and maintain good relationships with suppliers, banks and customers.

Importance of this resource

Controlling and monitoring this tool is essential to maintain a healthy cash flow and ensure business continuity. It allows:

• Finance sales in installments.
• Maintain inventories.
• Pay suppliers, taxes and salaries.
• Cover operating costs.

In short, the working capital It is the foundation that supports the company, allowing it to function even when returns on investments have not yet been obtained or sales are low. 

Therefore, monitoring and managing this indicator is crucial for business success.