Looking at a few numbers won’t necessarily give you an idea of how well a business is doing. While a company that brings in $100,000 a year looks far less profitable than one that grosses $500,000, that outlook changes if you know that the smaller business only spends $10,000 on overhead while the larger drops $400,000. Understanding your working capital in this big picture approach is the best way to know how stable your company actually is. Once you figure that out, you’ll be much better equipped to assess your cash flow situation.
Running a business means accounting for every dollar that comes from and goes to your company. It also means knowing how much worth you have in both assets and liabilities. It’s easy to look at your bottom line and compare that to the revenue generated by sales, but that doesn’t account for the money borrowed to purchase the inventory that generates the revenue to begin with. For any company to survive, much less grow, they must maintain their working capital ratio so that the assets outweigh the liabilities. If this ratio is below one and your company isn’t worth as much as it owes, there’s trouble on the horizon.
Alternatively, a ratio in excess of one means cash flow can potentially be put towards other expenses. After overhead is covered and debts are paid, excess cash can be turned into growth capital to cover the cost of future expansion. The longer you keep your debts on the right end of this ratio, the more your business can grow.
Cash flow is something that your business won’t always be able to predict. It would be ideal if you could keep profits steady throughout the year, though most businesses have to deal with months and quarters when consumerism is down. It’s during these dry spells that your working capital has to pick up the slack. Hopefully, it doesn’t come to liquidating assets that you had hoped to keep, but having that option can sometimes be the difference between your business staying open or folding. If your asset-to-liability ratio is good enough, it can help you weather the storm until your cash flow picks up again and allows you to reinvest in your company.
Both cash flow and working capital are vital to the success of your business, and each is reliant on the other. As the business owner, it’s up to you to make sure that you look at a full financial summary to understand how to best manage your money.Read More »