This key indicator reveals much about the health of your business at any given moment. Here's how to get more familiar with it.
I just met with a potential investor and he says I don't have enough working capital. (Lack of cash is the major reason why we need investors.) We have plenty of assets. I'm not sure why he sees working capital as such a key indicator?
-- Name withheld by request
It sounds like you're a little confused by the difference between assets and working capital. Working capital is an asset, but an asset isn't necessarily working capital.
Take cash: Cash is an asset you can use for a variety of purposes, like paying employee wages. If you own part or all of your building (meaning it's not fully mortgaged), the facility is also an asset--but unless you're willing to sell your building or borrow against it, then it's not working capital.
By the same token, the cool sculpture in your lobby is an asset but it's not working capital since you can't pay your lease with it.
So it sounds like your potential investor took a hard look at your Working Capital Ratio. The WCR evaluates how much of your assets are liquid and how many are relatively non-liquid. Working capital is the money you use to run the business, and the greater percentage of your assets are working capital the more liquid your company is and the better you can respond to changing business conditions--or just pay your bills.
Here's the formula for Working Capital Ratio:
WCR = Net Working Capital / Total Assets
Here's an example:
Your total assets are $500,000. That includes your building, your vehicles, your inventory, your cash, everything. Your working capital--your cash and other liquid assets--totals $200,000.
200,000 / 500,000 = .4, so your Working Capital Ratio is 40%.
(Keep in mind lenders often check out your WCR to determine whether you can survive short and longer-term dips in sales and revenue. Many lenders require businesses to meet a minimum WCR to qualify for loans, and then to maintain a certain level during the lifetime of the loan.)
So how do you improve your WCR? It's both easy and difficult: Keep spending to a minimum, try hard not to tie up your funds in fixed assets, keep inventories low, and try to tie every expense to generating revenue--not lobby sculptures.
Or you might try to shift the focus to another financial metric, Return on Assets. ROA measures the profit you make relative to your assets. Basically it evaluates how hard your money is working.
Here's the formula for ROA:
ROA = Net Income / Total Assets
Here's an example:
This month you generate $200,000 in net income. Your total assets are $125,000.
$200,000 / $125,000 = $1.60. Your company earned $1.60 for every dollar in assets.
Investors are especially interested in ROA since it measures the return on money they invest in your company. But ROA can vary wildly based on your industry; if you own a factory that manufactures furniture, a lot of your money is tied up in a large facility and expensive equipment; in that case your ROA will be relatively low. Generally speaking, capital-intensive businesses have a relatively low ROA.
On the other hand, if you run a consulting business out of your house your ROA should be very high because you should need very few fixed assets to maintain your operations.
Since Return on Assets evaluates results against your resources, it's an easy way to determine how effectively you're running your business. And if you want to attract investors, a high ROA is one way to do it.
Some other posts on metrics and financial calculations:
JEFF HADEN learned much of what he knows about business and technology as he worked his way up in the manufacturing industry. Everything else he picks up from ghostwriting books for some of the smartest leaders he knows in business. @jeff_haden