Net working capital is crucial to any business. It’s the metaphorical grease that keeps the machinery of your enterprise churning out sales and profits. Yet it is often overlooked and/or its need underestimated, especially in growing businesses.
People often joke about how “you have to spend money to make money”. This is most definitely true. That said, the focus of this phrase is often on the capital investments in land, property, plant, and equipment necessary to bring a project from concept to reality. While it’s true that every business requires capital expenditures, the attention afforded to big ticket items like machinery and equipment, can result in losing sight of working capital which is necessary to assure the machinery can be run.
So what is net working capital?
Defining Net Working Capital
In accounting lingo, net working capital by its simplest definition is the difference between a firm’s current assets and current liabilities (categorizations found on the business’s balance sheet). In normal peoples’ speech, it’s a measure of the short term ability of a business to generate sufficient incoming cash to make good on its promises to others.
Typically, the larger the business, the more net working capital needed to operate effectively. To take a simple example, if my business has one active project, it needs a certain amount of working capital to fund the business while we wait for payment from the customer. If I add a second active project, the need for working capital increases, as my obligations to employees, vendors, and others will likely expand. This expansion could be very profitable for my business, but in the short run it may put a strain on my cash position.
The Misunderstanding About Net Working Capital
When a business owner is considering a new opportunity, it is very easy to focus on margins. Perhaps a new piece of business offers a 30% net margin, which may be very attractive in a certain industry. While margins are a critical consideration for any new business opportunity, it’s also important to work on the net working capital needed to successfully deliver the new business. Depending upon the industry there could be days, weeks, months, or years of working capital needed to deliver successfully.
To get this right, it’s important to consider all the factors of production, lay them out in time sequence, and determine the implications for working capital. With this type of analysis you can understand if a project can be self funded or may require outside capital to successfully fulfill.
Does your Company need assistance with its growth plans? Reach out to Doescher Group for help.