Why Should You Learn How to Understand Working Capital?
Small business owners and managers have an important role to play in the health of the U.S. economy. Recently, on a national television news show, Tim Reynolds of the National Small Business Association presented the following information: There are more than 27 million small businesses in the U.S., accounting for more than 99.7 percent of all American businesses. Sixty-five percent of the fifteen million net new jobs created between 1993 and 2009 are attributed to small businesses.
U.S. small businesses employ more than half of all private sector employees. Since small businesses are so critical to the future of the U.S. workforce, a manager’s understanding of financial statements is imperative for the health of the economy as well as that of his or her own company.
Do you know how to read financial statements? Except for the very smallest businesses, financial statements should be prepared on a monthly basis. Financial statements prepared quarterly or less frequently present data 90 days or more old. Unless you’re an accountant, your financial statements should be prepared by a professional. Accounting is a highly technical subject, requiring a good deal of education, training, and experience. However, you can learn how to read, analyze, and interpret financial statements and to use them to help you run a more successful business. This article deals with current working capital and how to improve it.
The first category on the asset side of your balance sheet lists current assets; the liability side lists current liabilities. Current assets are items that are converted to cash within one year and are available to pay liabilities. Current liabilities are obligations which must be paid within one year. A partial balance sheet looks like this:
Accounts Receivable $50
Prepaid Expenses $10
Total Current Assets $200
Accounts Payable $40
Note Payable-Bank $40
Sales Taxes $7
Accrued Expenses $13
Total Current Liabilities $100
Working capital, sometimes called net working capital or current working capital, is the difference between current assets and current liabilities. Assuming all the above numbers are in the thousands, working capital in this case is $100,000. Another way to look at this is that there appears to be two dollars available in current assets to pay each dollar of current liabilities. The ratio of current assets to current liabilities is $200 to $100 or 2 to 1. Many people think that a ratio of 2 to 1 is good. As a matter of fact, some textbooks use the 2 to 1 ratio as a typical example.
However, the company in this example is facing a cash shortage because inventory of $120,000 and prepaid expenses of $10,000 are not available to pay current liabilities. Subtract these two numbers out of current assets, and only $70,000 is left to pay $100,000 in liabilities. The ratio is now $70 divided by $100 or 0.70. You simply will not be able to pay each dollar owed with 70 cents. This ratio is called a quick ratio or acid test ratio, and really is an acid test of your ability to pay your bills when due.