Most business owners think of Working Capital as the amount of cash they have in the bank. But CPAs. financial analysts, advisors and bankers define it as the difference between current assets and current liabilities. One sounds simple and easy to understand, the other a bit esoteric. Why do they make it so complicated? The answer: because it really matters.
Cash in the bank is real and always dependable – today. But what about tomorrow? Many business owners don’t get regular forecasts of future cash balances or future cash flows, which often results in a surprise when the customers don’t pay on time or an unexpected expense suddenly arrives at the door. If cash is tight that surprise can be alarming or worse.
So let’s look a little deeper. On your balance sheet are Current Assets, those things a company owns that are either cash or will become cash in the next 12 months, largely composed of accounts receivable and inventories. Those are the assets that will convert into cash for the purpose of paying the Current Liabilities, which are due for payment in the next 12 months.
A quick look at a company’s balance sheet will usually show that Current Assets are more than Current Liabilities – a good thing since that’s where the resources to pay the bills will come from. If the reverse is true, it may already be too late, but you should call us today 310.645.1091.
But wait a minute. What if the assets are only slightly larger than the liabilities? And what if the receivables contain some slow paying customers? And what if the inventories include some stock that is slow moving – meaning we hope it’s not dead yet? Now those assets are going to turn into cash more slowly, and some of them might not make the turn at all. Oops! It’s not likely you can call your creditors and tell them you’ve got to write down some of your assets so you’ll have to write down some of your liabilities too, to keep things in balance. Wouldn’t that make it easier?
So what’s the takeaway from this little financial management tidbit? Here are a few:
- The spread between current assets and current liabilities, if it’s consistently too narrow, may mean your margins are too thin, and that’s a whole different set of problems. If you want to better understand the causes, call the number above. (Call to action #2)
- Strive to have $2 of current assets for every $1 of current liabilities, just to provide a robust cushion against the issues noted above, so you can focus on running the business and not managing the bank account.
- If you manage your current assets carefully, your current liabilities will almost manage themselves. That means collect your receivables and pay attention to your inventory turnover. The fresher both are, the safer is your company’s bottom line.
If you manage your Working Capital effectively, you’ll always have cash in the bank, and that’s a good thing. We know, because we help our clients get that positive result – every day. After all…
We are Your CFO for Rent.