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As a startup owner, you may hear frequent talk of working capital. Working capital is an accounting and legal concept that refers to the relationship between your current assets and liabilities. Specifically, you measure it by taking your current assets and subtracting your current liabilities. This article will examine what working capital means for startups in more detail.
What is the Working Capital Formula?
For example, consider the following balance sheet.
| Amount | |
| Assets | |
| Current Assets | |
| Cash and Equivalents | £100,000 |
| Accounts Receivable | £80,000 |
| Inventory | £120,000 |
| Prepaid Expenses | £10,000 |
| Total Current Assets | £310,000 |
| Non-Current Assets | |
| Property, Plant, and Equipment | £400,000 |
| Investments | £150,000 |
| Intangible Assets | £50,000 |
| Total Non-Current Assets | £600,000 |
| Total Assets | £910,000 |
| Liabilities | |
| Current Liabilities | |
| Accounts Payable | £50,000 |
| Short-term Debt | £30,000 |
| Accrued Expenses | £20,000 |
| Total Current Liabilities | £100,000 |
| Non-Current Liabilities | |
| Long-term Debt | £200,000 |
| Deferred Tax Liability | £30,000 |
| Total Non-Current Liabilities | £230,000 |
| Total Liabilities | £330,000 |
| Equity | |
| Ordinary shares + share premiums | £100,000 |
| Retained Earnings | £480,000 |
| Total Equity | £580,000 |
| Total Liabilities & Equity | £910,000 |
The current assets are £310,000. The current liabilities are £100,000. Therefore, the working capital is £210,000.
Why is Working Capital Important?
Working capital is a way to gauge your startup’s short-term health. In other words, your startup’s working capital can measure how efficiently your startup manages its short-term financing needs.
Put simply, if your working capital is negative, you do not have enough assets to meet your liabilities in the short-term. Therefore, your startup may face insolvency.
On the other hand, if your working capital greatly exceeds your liabilities, you may not be adequately investing your startup’s capital.
However, you should not treat your working capital calculations in a vacuum. For example, suppose you have just purchased new equipment with cash. In this case, your working capital may temporarily be negative until you generate sufficient sales and collect your receivables, at which point, your balance sheet may return to normal.
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Considerations for Startups
For startups, working capital is crucial because it ensures the business can meet its short-term financial obligations and continue its operations smoothly. Specifically, adequate working capital is necessary to cover various expenses, including:
- rent;
- employee salaries;
- utilities;
- inventory purchases;
- marketing costs; and
- other overhead expenses.
Insufficient working capital can lead to liquidity problems, difficulty paying suppliers or employees, and potential business disruptions.
Startups frequently struggle to obtain outside short-term and long-term financing. Accordingly, this makes effective working capital management all the more critical. Moreover, you need to carefully manage your startup’s working capital so you can balance the need for long-term investment in growth and expansion while maintaining sufficient cash reserves to support ongoing operations. This requires:
- effective cash flow management;
- efficient inventory control;
- timely collections from customers; and
- strategic management of your trade payables.
Limits of Working Capital
Generally speaking, current assets include:
- cash and equivalents;
- accounts receivable;
- inventory; and
- prepaid expenses.
Working capital calculations rely on the premise that current assets are generally equivalent to cash. However, only cash and cash equivalents can be used to pay your overheads. Accordingly, if you have substantial current assets generally but little to no cash, you may be cash-flow insolvent.
For startups, this commonly happens when you have a disproportionate amount of outstanding trade receivables, which reflects unpaid invoices. Therefore, you should look behind your working capital calculations and ensure that you maintain:
- sufficient cash reserves in an easily accessible current account that offers competitive yields;
- adequate invoice collections policies that maintain customer relations without sacrificing your startup’s cash flow management; and
- necessary cash-flow management services such as factoring, invoice discounting, and bank overdrafts.
Further Considerations
Other ways to improve your startup’s working capital include prepaying certain expenses with your cash reserves. While this will not immediately change your current asset figures (you are exchanging cash for prepaid expenses), this can benefit your business over time. This is especially true when you will likely generate fewer sales/trade receivables. By prepaying expenses when you have more cash, you effectively loan your startup the value of not worrying about future expenses.
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Key Takeaways
Working capital is crucial for startups, as it measures the relationship between a company’s current assets and liabilities. Moreover, it represents the ability to meet short-term financial obligations and manage cash flow efficiently. Calculating working capital involves subtracting current liabilities from current assets. It provides insights into the health and liquidity of your startup. Adequate working capital is essential for startups to cover various expenses and avoid liquidity problems. Effective working capital management involves maintaining sufficient cash reserves, optimising inventory control, and implementing timely collections and trade payables management strategies. In addition, startups should consider prepaying certain expenses to improve working capital over time.
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Frequently Asked Questions
Working capital is crucial for startups because it ensures they can meet their short-term financial obligations.
Startups can improve their working capital by maintaining sufficient cash reserves, implementing effective invoice collections policies, and considering cash-flow management services like factoring and invoice discounting.
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