One mistake many start-ups make is not managing working capital sufficiently and improving cash flow early on.
It is worth looking into this topic, especially for start-ups, as optimising working capital can be critical to a company’s success and growth.
Read about the definition of working capital and tips on how you can improve it in the short term!
Companies that want to grow sometimes need to free up capital
To optimise cash flow, you need to understand future needs, liabilities and revenues, and consider a temporary increase in working capital. Working capital has a major impact on different parts of the business, from paying salaries and any supplier costs to paying rent, utility bills or new projects and future investments.
The definition of working capital is often simplified to include only the amount of money available to meet short-term obligations. What working capital actually means in detail, and why optimising free capital is important for start-ups in the growth phase, is explained in this article.
The definition of working capital
The term working capital describes the difference between a company’s current liabilities and its current assets. It consists of:
- Cash and cash equivalents
- Prepayments made
- Current liabilities
- Prepayments received
Working capital thus evaluates a company’s ability to pay its current liabilities with its current assets and provides an indication of the company’s short-term financial health. The ability to pay debts within one year, liquidity and operational efficiency can also be derived from this. Knowing the importance of optimised working capital and its impact can give companies a crucial competitive advantage in the marketplace.
Calculating working capital
Working capital is calculated using the current ratio, which is the result of current assets divided by current liabilities. It can be expressed by the formula
Current assets/liabilities = working capital
A ratio above 1 means that the company’s assets can be quickly converted into cash, and that the company is therefore considered to have sufficient capacity to pay off its current liabilities with current assets. The higher the ratio, the more likely an enterprise is to be able to meet its short-term liabilities and debt obligations. Perhaps more importantly, the higher the measure a company has, the less likely it is that it will need to take out a loan to finance the growth of its business.
A company with a ratio less than 1 is considered risky by investors and creditors because it indicates that the company may not be able to pay off its debts. A ratio of less than 1 is called negative working capital.
What can you do to strengthen your working capital in the short term?
Selling invoices through factoring
Selling invoices (also called buying invoices) through so-called factoring works by selling your outstanding receivables to a factoring provider – whereupon the amount of the invoice (minus a fee) is paid to you immediately. This creates quick liquidity and the opportunity to plan your own cash flow more efficiently – for example, when paying salaries, launching new projects, buying machinery, etc.
A loan involves entering into an agreement with a lender – usually a bank. The lender wants to be paid for lending money. You therefore pay interest on an ongoing basis and in some cases also a processing fee each time you pay off your loan. When you apply for a loan from the bank, you usually need to be able to present your company’s business plan and budget. This is necessary so that the lender can assess the risk the loan poses to the bank.