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Advantages and disadvantages of working capital

the advantages and disadvantages of working capital

What is working capital and why does it matter?

Working capital is a key indicator of the health of your business. Calculated as the sum of current assets minus current liabilities, it reflects the money your company has available that isn’t tied up in the day-to-day cost of doing business. Working capital can demonstrate whether or not the company can meet all of its short-term debts, such as salaries and supplier invoices, when they become due.

Positive working capital suggests a company is in good health; if the business has a positive balance once all liabilities are subtracted, it has some degree of profitability. Negative working capital, however, can be an indicator that processes within the business aren’t working, such as sluggish sales or mounting customer debts.

How much do you need?

How much working capital a business needs is unique to each one – it can depend on the type of business and its industry, for example. Retail companies usually have a greater need for working capital, as the purchase of stock ties up their money until the stock is sold, which can take time. It can be more difficult for smaller businesses to raise finance quickly than larger businesses, so if you’re operating a small business, it’s important to maintain positive working capital.

Working capital and stock

Working capital is often linked with stock. Large amounts of obsolete or slow-selling stock can impact the amount of working capital your company generates. The longer working capital is tied up in old stock or unpaid customer invoices, the less money you’ll have to reinvest into the company. Tying up working capital in old stock or customer debts for long periods of time can impact your business’s ability to sustain itself. Large amounts of unpaid invoices can affect your ability to raise finance or negotiate terms with suppliers for new stock, but without new stock for your business your sales might suffer. Your ability to buy stock will be hindered without sales, in turn reducing your company’s working capital. This scenario can quickly harm your company.

Working capital and overtrading

Overtrading can happen when a company makes purchases without the sales to pay for them or when it promises customers more than it can deliver. Each of these situations has a ripple effect on the amount of working capital the company has, as its cash assets may have been consumed by the stock or services needed to fill customer orders. With cash tied up in the new stock, the company could find itself in the difficult position of paying invoices and bills late until payment for the stock comes in, which could take weeks depending on the contract and customer relationship. Like a rubber band, the cash is stretched to meet customer expectations, but when stretched too far, something could snap.

The advantages and disadvantages of working capital

One of the advantages of working capital is that you have more flexibility, enabling you to satisfy your customers’ orders, expand your business, and invest in new products and services. It also provides a cushion for when your company needs a bit of extra cash.

While having positive working capital is a good thing, having too much of it can limit the success of your company. An excess of working capital can reveal that the business isn’t taking opportunities to grow or isn’t aware of them.

The disadvantages to negative working capital range from paying your suppliers late to the threat of bankruptcy/liquidation. How serious this is depends on why the amount is negative; if it’s due to a one-off investment into new stock that is promptly paid for, you might avoid paying your debts late. Repeated purchases of excess stock or an increase in customer debt can have significant consequences for your company.

Need more working capital?

A loan could bridge the finance gap between customer orders and supplier payments. By using a loan for working capital, you can free up cash for your business growth or expansion plans without relying on your invoices to raise finance. It can also help seasonal businesses manage their cash flow during peak and low seasons.

For more information about how a LendingCrowd loan can help your business, learn more about our requirements online or call us on 0345 564 1600.

advantages and disadvantages of working capital

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Lending Crowd

Lending Crowd

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