Working capital – an introduction
Working capital is a metric used to measure an e-commerce company's liquidity, operational efficiency, and short-term financial health. It’s a calculation of the total amount of a company's current assets minus its current liabilities. Current assets includes things such as cash, accounts receivable, inventory and any other liquid assets that can be quickly converted to cash. While current liabilities are all the debts and obligations that must be paid within a year, such as accounts payable, wages, and taxes. Understanding and using this metric can help your e-commerce business stay profitable and help you manage your finances effectively.
What is working capital?
Working capital represents the amount of capital a business has available to fund its day-to-day operations. It is not just money in the bank but includes a range of assets that can be readily converted into cash, such as inventory, accounts receivable, and cash itself. It’s the difference between these current assets and current liabilities (accounts payable, accrued expenses, etc.). In simpler terms, working capital is the capital available to the business to manage its day-to-day activities.
Why is working capital so important?
Working capital is critical for e-commerce businesses because it affects their ability to run their operations effectively. Without sufficient working capital, an e-commerce brand may struggle to pay suppliers and hold sufficient inventory, which can lead to a loss of credibility and trust in the market. With a lack of working capital, a growing business may also be unable to take advantage of new opportunities or expand its operations, resulting in limited growth.
Managing working capital is fundamental in managing a business. Even profitable businesses can go out of business because they don’t have the working capital to operate, so it’s really important to get this right.
On the flip side, a business may intentionally run with negative working capital as a strategy to optimise cash flow or take advantage of trade credit terms. For example, a marketplace business may rely on collecting funds from customers, before paying out to the demand side of the marketplace.
However, running with negative working capital for an extended period could be risky. You rely on continued growth for the above example to work. This could potentially lead to cash flow issues, difficulty paying suppliers or employees. Negative working capital can also limit a business's ability to invest in growth opportunities or respond to unexpected expenses or emergencies.
Working capital cycle (also known as the cash conversion cycle) is an important metric to go along side understanding working capital but are two very different things. Working capital cycle is a measure of the time it takes for a business to convert its current assets into cash. It represents the time it takes for a business to purchase inventory, sell it, and collect cash from customers. The working capital cycle is calculated by adding the number of days it takes to sell inventory, the number of days it takes to collect accounts receivable, and subtracting the number of days it takes to pay accounts payable.
What is a good working capital?
Good working capital for an e-commerce business is one that enables the business to meet its short-term financial obligations while maintaining sufficient liquidity to fund its long-term growth. Typically, a positive working capital, meaning that the business has more current assets than current liabilities, is considered ideal. However, the optimal amount of working capital varies depending on the size and circumstances of the e-commerce business.
While positive working capital is typically good, if it were all tied up in inventory, and you had no available cash, you could be a problem too – as while it’s seen as current, if it takes 90 days to turn that inventory into cash then your working capital cycle may be too long.
Managing inventory levels is typically considered one of the most critical areas for e-commerce businesses, making demand planning a priority. Not only will having too much inventory tie up working capital and it will also increase carrying costs (warehouse etc.), while having too little inventory can lead to stockouts, lost sales and an impact to brand reputation.
Monitoring slow moving stock and selling it at cost or a low margin will free up working capital that can be re-invested. It will also free up warehouse space which can be repurposed or reduce costs if a 3PL is involved.
Seasonality also has an impact for many businesses, if you were selling snowboards, demand in summer months will be lower, but leading up to winter you will need to stock up with higher quantities. These fluctuations can be hard to manage and impact the working capital cycle – during summer operating costs could cause cashflow issues because inventory is slow moving and tied up in working capital.
What does working capital look like?
How do you calculate working capital?
The formula to calculate working capital is:
Working capital = Current Assets - Current Liabilities
Where current assets equate to all the assets that the business owns and expects to convert into cash within one year. Examples of current assets include cash, inventory, accounts receivable, and short-term investments.
Where current liabilities equate to all the business's obligations that are due within one year, such as accounts payable, taxes owed, and short-term loans.
Working capital worked example
If a business has the following current assets and liabilities, its working capital is £60,000, calculated like this:
- Cash £35,000
- Inventory £85,000
- Accounts receivable £15,000
- Accounts payable £45,000
- Accruals £30,000
Working capital = (£35,000 + £85,000 + £15,000) – (£45,000 + £30,000) = £60,000
Conclusion
Working capital is a crucial concept for e-commerce businesses to understand. Without sufficient working capital, a business may struggle to operate effectively, miss out on growth opportunities or even run out of money. A positive working capital, where current assets exceed current liabilities, is ideal for most businesses. By calculating working capital regularly, e-commerce businesses can monitor their financial health and make informed decisions to optimise their working capital. This should consider this alongside other metrics such as working capital cycle.
