Liquidity & Capital

Working capital is possibly the most misunderstood financial term in business. To explain what it is, how it works, and why it is so critical to businesses, please allow us to share a simple example:
 

Let’s imagine your business is a retail store that sells iPods. On September 1st you buy one iPod for $100. The vendor from whom you purchase the iPod expects cash on delivery (COD), so you pay $100 dollars. You put the iPod on a shelf in your retail store, and it sells 30 days later for $200. Your customer pays you with cash at the point of sale. Your working capital for this iPod is the $100 you invested into the iPod for 30 days until you received $200 for selling it. 

 
This example is for one item in one store. Now imagine you sell one thousand different kinds of products in your retail store. Some of your suppliers require COD terms; others might extend net 30 or 60 day terms (this means you don’t need to pay them until 30 or 60 days from the date you receive the product). In this example, the amount of money you have spent for the products on your shelves represents your working capital.
 
The more diverse your mix of products and services combined with the varying payment terms of your vendors and customers comprise the complexities of your working capital. Businesses that understand their working capital requirements and how their working capital changes with product, service, vendor, and customer changes will always have enough liquidity in to keep their businesses running strong. growing_business-capital
 
So, is it good to have a large or small working capital? What is the optimal working capital of my business? The answers to these questions depend on your industry, your rate of growth, and several other factors in your business. 
 
In our role as part-time CFO, we help our clients understand their working capital and we monitor it so that the business remains liquid. As changes in the business arise, we help guide our clients to the most value-added strategic decisions that will help the firm operate at its optimal level of working capital.
 
The actual definition of working capital is your current assets minus your current liabilities. Your current assets will almost always turn into cash within the next 12 months, and your current liabilities represent the things for which you must pay in the next 12 months. Here is a sample of the critical elements of the formula:

 

Current Assets
 
 

 
Cash
        $  50,000

 
Accounts Receivable
$200,000

 
Inventory
$100,000

 
Pre-Paid Items
$  10,000

 
TOTAL CURRENT ASSETS
$360,000

 
 
 

Current Liabilities
 
 

 
Accounts Payable
$175,000

 
Credit Cards
$    5,000

 
Line of Credit
$  20,000

 
Accrued Expenses
$  10,000

 
TOTAL CURRENT LIABILITIES
$210,000

 
 
 

 
WORKING CAPITAL 
$150,000