The Importance of Keeping Your Working Capital Positive

There are plenty of numbers to focus on within your accounting reports (net income anyone?), but you can also learn volumes about your business’s financial health by understanding certain metrics and ratios. One of the metrics we love to use with our clients is Working Capital, which provides a quick glance at the short-term financial health of a business. Below, we’ll talk about what Working Capital is and how you can use it to understand the financial side of your business. If the details start to overwhelm you, skip ahead to the WHY section for a short and sweet take away.

What is Working Capital?

In accounting terms, Working Capital is the difference between your Current Assets and Current Liabilities:

Current Assets - Current Liabilities = Working Capital

Or, to make it a little easier:

What you own - What you owe = Working Capital

Easy enough, right? But let’s break it down below so you know exactly what we’re talking about.

Assets - What You Own

What you own is presented to you on your Balance Sheet under the “Assets” section, or the top of your balance sheet. This includes the following:

  • Cash (Checking and Savings accounts)

  • Accounts Receivable (What your clients owe you)

  • Undeposited Funds (Payments that haven’t cleared the bank)

  • Fixed Assets (Furniture, Fixtures, Autos, Computer Equipment)

Like we mentioned above, when we look at Working Capital, we want to look at Current Assets or items on your balance sheet that are liquid within one year. Cash is definitely liquid, and you’ll likely collect on your Accounts Receivable within the next year. You’ll also likely deposit any payments you’ve received within the next year (hopefully within the next week), so these three items are considered “current.” Fixed assets, such as furniture, cars and computer equipment, typically have useful lives between three and seven years and wouldn’t be considered “current” for financial purposes.  

Liabilities - What You Owe

What you owe is presented on your Balance Sheet under the “Liabilities” section, or the second half of your balance sheet. This includes the following:

  • Credit Cards

  • Accounts Payable (What you owe to vendors)

  • Client Deposits (Money clients have given you to begin work)

  • Sales Tax Liability (What you owe the government for sales tax)

  • Loans (Money you have borrowed and owe back to the creditor)

Again, we want to look at the current portion of your Liabilities for Working Capital purposes; for Liabilities, “current” means anything you will owe within one year. Your Credit Cards are due within the month, you’ll likely pay your vendors within the year, you may owe your client their deposit back if you do not finish the work or they decide to go in a different direction, and you’ll owe your sales tax liability within one year at least. Loans can go either way, although many will have a term longer than one year. Remember, anything you owe within one year is considered “current.”

Why What You Own Should Outweigh What You Owe

If we simply sit back and think about it, it makes sense that a financially viable business would own more than it owed. Working Capital looks at what you own that can be liquidated in the next year and compares it to what you owe within the next year.

A positive Working Capital means you can pay your obligations when they become due, assuming your current assets are relatively liquid (can be converted to cash quickly). For Interior Designers, the most common Current Assets are Cash and Accounts Receivable, both of which can be converted to cash relatively quickly, assuming your clients are good about paying you. A positive Working Capital indicates that your business has good short term financial health, which will help you secure debt funding, such as a loan. Keeping an eye on this metric also just makes you feel confident in your business as you continue to grow, and who couldn’t use a little more peace of mind in their lives?

If this balance shifts and your Working Capital becomes negative, there’s a chance you won’t be able to meet your obligations on time. You may miss paying your credit card bill when it’s due or be unable to pay your vendors. This isn’t good for your financial health or your business’s reputation; maintaining a positive Working Capital will help you avoid both of these situations.

How to Calculate Working Capital

Like we mentioned above, you can calculate Working Capital by looking at the difference between your Current Assets and Current Liabilities:

Current Assets - Current Liabilities = Working Capital

Or the easier version:

What you own - What you owe = Working Capital

We provide a detailed Working Capital calculation to our clients on a quarterly or monthly basis, so they can address any dips or variations as quickly as possible. Our goal is to help our design clients succeed in building a business and lifestyle they love, and analyzing and correcting Working Capital is a great way to help them achieve their goals.

You can incorporate Working Capital into your monthly financial routine by simply using the formulas above, and start having more insight and peace of mind about your business.