Working capital is a financial metric that measures a company's liquidity and operational efficiency. It is the difference between a company's current assets and current liabilities. Understanding working capital is essential for both business owners and investors, as it provides insights into a company's financial health and growth potential.

In this article, we’ll explain what working capital is, how to calculate it, and how to improve it so you can grow your business faster and achieve your creative goals.

Fast Facts About Working Capital

• Working Capital equals current assets minus current liabilities: WC = CA - CL

• Working Capital can indicate a business’s liquidity and operational efficiency

• Liquidity is how easily or quickly a business’s assets can be converted into cash

What is Working Capital?

Working capital is the net current assets available to a business to fund its day-to-day operations. It's a measure of a company's short-term financial health, its ability to fund its growth, and its ability to meet its immediate obligations, such as debt and upcoming expenses.

How to Calculate Working Capital

The working capital formula is current assets minus current liabilities. For example, if a business has $50,000 in current assets and $30,000 in current liabilities, its working capital would be $20,000:

$50,000 (Current Assets) - $30,000 (Current Liabilities) = $20,000 (Working Capital)

What are Current Assets?

Current Assets are either cash or assets that can be converted into cash within one year. Common current assets include:

• Cash and Cash Equivalents: Money on hand, in bank accounts, or in short-term investments.

• Accounts Receivable: Money owed to the company by customers for goods or services already delivered.

• Inventory: Products held for sale or use in production.

• Prepaid Expenses: The portion of any costs paid in advance, such as rent or insurance, which you will benefit from in one year or less.

What are Current Liabilities?

Current Liabilities are short-term debts that must be paid within one year. Common current liabilities include:

• Accounts Payable: Money owed to suppliers for goods or services already received.

• Short-Term Notes Payable: Short-term loans that must be repaid within one year.

• Accrued Expenses: Expenses that have been incurred but not yet paid, such as wages or taxes.

Working capital measures a company's liquidity and operational efficiency. It's the difference between a company's current assets and current liabilities.

The Importance of Working Capital for Business Growth

A strong working capital position is vital for business growth and sustainability. It enables companies to:

• Fund Operations: Cover expenses like payroll, rent, and creative purchases.

• Take Advantage of Opportunities: Seize new business opportunities, such as expanding into new markets, purchasing upgraded creative gear, or renting a studio.

• Manage Cash Flow: Smooth out cash flow fluctuations and low-cash times.

• Weather Economic Storms: Cope with economic downturns, unexpected challenges, losing clients, etc.

• Attract Investors: A healthy working capital position can make a company more attractive to potential investors, whether friends & family or banks.

How to Improve Working Capital

The basis of improving working capital is increasing your current assets, decreasing your current liabilities, or both. More specifically, there are several strategies that small businesses can use to improve their working capital. These include...

Improve Your Inventory Management

Optimize inventory levels to minimize holding costs and avoid stockouts. If you sell creative merchandise like prints, art, or other physical items, you can work on stocking only the inventory you’ll sell in the short term. This frees up capital to invest in other areas of your business.

Accelerate Accounts Receivable (Collect Payments Faster)

Implement strategies to collect payments from customers and clients more quickly, such as offering early payment discounts. Similarly, as a creative, you’re probably used to cultivating close relationships with your clients and customers. This friendliness can improve your accounts receivable collection, allowing you to receive cash more quickly.

Negotiate Better Payment Terms with Suppliers

Negotiate your payment terms with clients and creative suppliers to improve cash flow. This allows you to lower your costs by negotiating better rates and payment terms with your supplier. This works especially well if you purchase large volumes of creative supplies, like paint brushes, paper, rolls of film, sticker paper, art supplies, textiles, etc.

Obtain Financing like Loans or Lines of Credit

Explore financing options like loans, lines of credit, or invoice factoring to increase short-term liquidity. This is especially useful when you’re experiencing profitable growth as it can allow you to invest in new gear such as cameras, monitors, art studios, better raw materials, etc.

Reduce Your Operating Costs

Identify cost-cutting measures to improve profitability and free up cash. For example, if you consistently rent a studio but use it infrequently, it may be more cost-efficient to convert an area of your home into a studio and rent an external studio as needed.

The Best Accounting Software for Creative Businesses

To effectively manage working capital, businesses big and small can leverage accounting software to automate financial processes and gain real-time insights. Popular accounting software options include:

• QuickBooks: A user-friendly solution for small businesses.

• Xero: Cloud-based accounting software with powerful features.

• Zoho Books: Affordable and scalable accounting software.

• FreshBooks: Designed for freelancers and small businesses.

Take a look at our financial basics for creatives article to learn more.

Conclusion

Working capital is a critical financial metric that reflects a company's ability to meet its short-term obligations and fund its operations. By understanding the components of working capital and implementing strategies to improve it, businesses can enhance their financial health and position themselves for long-term success.

Frequently Asked Questions (FAQs)

What is the difference between working capital and cash flow?

Working capital measures short-term liquidity (current assets minus liabilities), while cash flow tracks cash movement over time. Working capital shows resources for daily operations; cash flow ensures obligations are met.

Can a company have too much working capital?

Yes. Excess working capital may indicate inefficiency, like holding too much inventory or underinvesting in growth. Balancing working capital is crucial for operational efficiency.

How does working capital impact a company's ability to secure loans?

Lenders assess working capital to gauge repayment ability. Healthy working capital improves loan approval chances, while poor management can deter lenders.

What are the risks of negative working capital, and how can businesses address it?

Negative working capital signals financial distress. Businesses can fix it by speeding up receivables, cutting costs, renegotiating supplier terms, or securing short-term financing.

How does industry type affect working capital requirements?

Working capital needs vary by industry. Retailers may need more for inventory, while service businesses require less. Understanding industry benchmarks helps tailor financial strategies.

Disclaimer: the information provided in this article is for educational purposes only and does not constitute tax, accounting, investing, legal, or financial advice. The information in this article does not take into account your unique financial or business situation or goals, and YCCPA cannot be responsible for reader's financial decision-making. YCCPA's goal is to educate and support you on your creative business journey.

Written by David Kindness, CPA

David is a CPA (Certified Public Accountant) and professional photographer, videographer, and designer based in San Diego, California. Learn more.

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