Everything You Need to Know About Working Capital

Wednesday, 16 Sep 2020

Working capital can be regarded as the lifeline of a business as it accounts for the available funds that support its day-to-day operations. It signifies the liquidity or current financial standing of the business and can be calculated by deducting current liabilities from the current assets.

The working capital is a component of the operating capital, which also includes plant and equipment. It helps the entrepreneur to understand the financial capabilities of the venture and determine whether it can meet its debts or not.

Bookkeepers in Melbourne play a significant role in maintaining a positive working capital which supports the growth of the business. They ensure that the business owner makes sound investments and do not let the liabilities exceed the assets.

Thus every entrepreneur must be aware of working capital and how it can be maintained. So here is a rundown on everything that you need to know about this valuable financial component.

What Is Working Capital And Its Ratio?

Working capital is the money available to a company that is needed for trading. It could be gained by applying for a business loan in Melbourne or making profits from the sales of goods and services.

It allows the entrepreneur to pay for the regular expenses while operating, such as the ongoing costs of the office lease, utilities, salaries and wages to employees, administration expenditure, etc. It can be calculated by using the formula, Working Capital = Current Assets – Current Liabilities. Thus the assets must always be higher than liabilities (short-term debts which should be paid in the next twelve months).

Your bookkeeper will also calculate the working capital ratio to determine if the working capital is sufficient or not. The working capital ratio (current liabilities/current assets) denotes the financial well-being of the business. If the ratio is less than one, then the company has negative working capital.

On the other hand, if the ratio is between 1.2 and 2.0, then it has a positive working capital. If the ratio is higher than two, then it implies that the business has an excess of assets that are not being utilised efficiently. It suggests that the entrepreneur has not been able to capitalise on the available opportunity or does not have the support of an able bookkeeping company. A negative working capital points towards the poor performance of the Melbourne-based business.

Types of Working Capital

Working Capital is also known as circulating capital as it can change its form from cash into stock and back into cash quickly. Thus it has several types which are mentioned below.

  • Gross Working Capital – It is the total amount of current assets available in the company.
  • Net Working Capital – Working capital is also known as net working capital and is the difference between current assets and current liabilities.
  • Permanent Working Capital – It is the capital that should stay permanently invested.
  • Variable Working Capital – It is the capital which is invested for a short period, unlike the permanent working capital, which is a long-term investment.
  • Reserve Margin Working Capital – It is reserve funds that business in Melbourne needs in times of an unforeseen crisis to stay afloat, such as an economic downturn or a massive decrease in sales.

Why Is It Essential For A Business To Have Working Capital?

Working capital is vital in sustaining the business through rough periods, such as a slow-growth phase or a slowdown in the industry. Thus working capital management is crucial for every entity operating in Melbourne. Here is how it supports a venture.

  • Sufficient working capital helps in maintaining the liquidity in the organisation.
  • It is also needed to fund projects which get payment from the client at the time of delivery.
  • It allows the entrepreneur in Melbourne to invest in the latest equipment and purchasing inventory whenever required without facing a cash deficit. Thus the work does not get affected due to lack of capital at any point in time.
  • Merely earning profits does not help the business to pay the dividends. Sufficient working capital makes timely payments possible.
  • A satisfactory amount of working capital ensures that the creditors are paid without any delay, which helps in promoting the credibility of the business.   
  • Ample working capital ensures that the business enjoys a positive credit history and gets a loan from the money lenders in Melbourne without any hassles or tedious paperwork.

Determining The Amount Needed For Sufficient Working Capital

Calculating the exact amount needed for the smooth functioning of the business is not an easy task. A professional bookkeeper can help in this regard with his expertise and skills to establish adequate working capital for a specific business. Here are the factors that aid in deciding the right amount.

  • The type and size of the business entity help in ascertaining its working capital. A small business in Melbourne, which is selling fast-moving consumer goods will need less working capital as the flow of cash will be adequate to manage the expenses. On the other hand, a finance-related large company will need more working capital. Your bookkeeper is the best person to identify the amount.
  • The turnover of the business plays a significant role in assessing its working capital. If the raw material is cheaper and is sold quickly, then the company needs less working capital. In contrast, if the investment on stock is higher and the return is lower, then the working capital needs to be large.
  • Companies in Melbourne which have more automated procedures and lower workforce need small working capital whereas firms which have a huge workforce need large working capital.
  • If the entrepreneur is making most of the purchases on credit instead of cash payments, then it requires less working capital. However, your bookkeeper is the best judge in matters of finance, so make sure to get his advice.

How To Avoid Working Capital Shortage?

Many businesses face a working capital shortage in Melbourne while trading, and it can affect the daily operations. Your bookkeeper plays the key in managing the optimum working capital balance. In case of a deficit, you can look at these sources:

  • Get payments from clients sooner through a robust invoicing process and charging penalties on late payment. You can also introduce offers on early payments. Your bookkeeper can help you with following up with the clients and sending invoices without any delay.
  • Do not allow clients to make the payment at the time of delivery for a long project. Ask for an upfront deposit to keep the work progressing.
  • Moneylenders and small business loans can assist in the times of shortage of working capital. Bookkeepers are usually helpful in finding loans at a lower interest rate.
  • Make sure that there are no hidden charges when you are lending money in Melbourne and also do not get into a huge debt by applying for a big loan.

Conclusion

Working capital is the most basic requirement for running a business, and thus, you must understand it in detail. Your bookkeeper in Melbourne can guide you in making the best use of this money and keeping it available for the business operations.

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