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Working Capital Basics

Working Capital Basics

Working capital is the difference between a company's current assets, such as cash, accounts receivable (customers' unpaid bills) and inventories of raw materials and finished goods, and its current liabilities—such as accounts payable.

Working capital assesses a company's ability to pay its current liabilities with its current assets, giving us an indication of the company’s short-term financial health, the capacity to clear its debts within a year, and operational efficiency.

Working capital represents the difference between a company’s current assets and current liabilities. The challenge here is determining the proper category for the vast array of assets and liabilities on a corporate balance sheet and deciphering the overall health of a company in meeting its short-term commitments.

KEY TAKEAWAYS

  • Working capital is the amount of available capital that a company can readily use for day-to-day operations.
  • It measures a company's liquidity, operational efficiency, and short-term financial health.
  • To calculate working capital, compare a company's current assets to its current liabilities, for instance by using the current ratio.

 

Components of Working Capital 

What comprises working capital? Let's take a look. 

Current Assetscannabis working capital

This is what a company currently owns—both tangible and intangible—that it can easily turn into cash within one year or one business cycle, whichever is less. Obvious examples of current assets include checking and savings accounts; highly liquid marketable securities such as stocks, bonds, mutual funds and exchange-traded funds (ETFs); money market accounts; cash and cash equivalents, accounts receivable, inventory, and other shorter-term prepaid expenses.

Current Liabilities

In a similar fashion, current liabilities are all the debts and expenses the company expects to pay within a year or one business cycle, whichever is less. This typically includes the normal costs of running the business such as rent, utilities, materials and supplies; interest or principal payments on debt; accounts payable; accrued liabilities; and accrued income taxes.

How to Calculate Working Capital

Working capital is calculated by using the current ratio, which is current assets divided by current liabilities. A ratio above 1 means current assets exceed liabilities, and, generally, the higher the ratio, the better.

Current Ratio = Current Liabilities/Current Assets​​

working capital basics What Working Capital Means  

A healthy business will have ample capacity to pay off its current liabilities with current assets. A ratio of above 1 means a company's assets can be converted into cash at a faster rate. The higher the ratio, the more likely a company can honor its short-term liabilities and debt commitments. 

A higher ratio also means the company can easily fund its day-to-day operations. The more working capital a company has, the less it’s likely to have to take on debt to fund the growth of its business. 

A company with a ratio of less than 1 is considered risky by investors and creditors since it demonstrates that the company may not be able to cover its debt if needed. A current ratio of less than 1 is known as negative working capital.

Factoring vs Asset Based Financing

A factor is an intermediary agent that provides cash or financing to companies by purchasing their accounts receivables. A factor is essentially a funding source that agrees to pay the company the value of an invoice less a discount for commission and fees. Factoring can help companies improve their short-term cash needs by selling their receivables in return for an injection of cash from the factoring company.

 

KEY TAKEAWAYS

  • A factor is essentially a funding source that agrees to pay a company the value of an invoice less a discount for commission and fees.
  • The terms and conditions set by a factor may vary depending on its internal practices.
  • The factor is more concerned with the creditworthiness of the invoiced party than the company from which it has purchased the receivable.

 

Benefits of a Factor

The company selling its receivables gets an immediate cash injection, which can help fund its business working capital cannabis businessoperations or improve its working capital. Working capital is vital to companies since it represents the difference between the short-term cash inflows (such as revenue) versus the short-term bills or financial obligations (such as debt payments). Selling, all or a portion, of its accounts receivables to a factor can help prevent a company, that's cash strapped, from defaulting on its loan payments with a creditor, such as a bank.

What Is Asset-Based Finance?

Asset-based finance is a specialized method of providing companies with working capital and term loans that use accounts receivable, inventory, machinery, equipment, or real estate as collateral. It is essentially any loan to a company that is secured by one of the company's assets.

Asset-based funding is often used to pay for expenses when there are gaps in a company's cash flows, but it can also be used for startup company financing, refinancing existing loans, financing growth, mergers and acquisitions.

KEY TAKEAWAYS

  • Asset-based financing is a way for companies to use property, inventory, or accounts receivable as collateral to obtain a loan. 
  • These types of loans may be more flexible than traditional commercial loans; however, the downside of this type of arrangement includes high financing costs.
  • ·Asset-based loan financing may be used by companies that need short-term working capital to keep day-to-day operations, like payroll, for example, up and running.

Understanding Asset-Based Finance

An example of asset-based finance would be purchase order financing; this may be attractive to a company that has stretched its credit limits with vendors and has reached its lending capacity at the bank. The inability to finance raw materials to fill all orders would leave a company operating under capacity and could put the company at risk for closure.

Under a purchase order financing arrangement, the asset-based lender finances the purchase of the raw material from the company's supplier. The lender typically pays the supplier directly. After the orders are filled, the company would invoice its customer for the balance due. The accounts receivable set up at this time would typically be paid directly from the customer to the asset-based lender.



Posted by Michael Rattelmeier

Cofounder, Canna Business Financing


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