As a business owner, it is important to know the difference between working capital and changes in working capital. Working capital tells you the level of assets your business has available to meet its short-term obligations at a given moment in time. Change in working capital, on the other hand, measures what is happening over a given period of time with regard to the liquidity of your company.
Changes in working capital are important to monitor and are often used by investors and lenders to assess the health and value of a business. Read on to learn what causes a change in working capital, how to to calculate changes in working capital, and what these changes can tell you about your business.
What Is Working Capital?
Working capital is a company’s current assets minus its current liabilities. Both current assets and current liabilities are found on a company’s balance sheet.
Current assets include assets a company will use in fewer than 12 months in its business operations, such as cash, accounts receivable, and inventories of raw materials and finished goods. Current liabilities include accounts payable, trade credit, short-terms loans, and lines of credit. Essentially, working capital is the amount of money a company has available to pay its short-term expenses.
Positive Working Capital
A business has positive working capital when it currently has more current assets than current liabilities. This is a sign of financial health, since it means the company will be able to fully cover its short-term obligations as they come due over the next year.
It’s possible to have too much of a good thing, however. Excessive working capital for a prolonged period of time can mean a company is not effectively managing its assets.
Negative Working Capital
A business has negative working capital when it currently has more liabilities than assets. This can be a temporary situation, such as when a company makes a large payment to a vendor. However, if working capital stays negative for an extended period, it can indicate that the company is struggling to make ends meet and may need to borrow money or find another way to finance their working capital.
Another way to measure working capital is to look at the working capital ratio, which is current assets divided by current liabilities. Generally, a working capital ratio of less than 1.0 is an indicator of liquidity problems, while a ratio higher than 2.0 indicates good liquidity.
What Is Net Working Capital?
Net working capital is simply another name for working capital. It is a basic accounting formula companies use to determine their short-term financial health. The basic formula is: Current Assets – Current Liabilities = Net Working Capital (or Working Capital)
What Are Changes in Net Working Capital?
Changes in net working capital refers to how a company’s net working capital fluctuates year over year. If your net working capital one year was $50,000 and the next year it was $75,000, you would have a positive net working capital change of $25,000.
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What Causes Changes in Working Capital?
There are a number of factors that can cause a change in working capital. These include:
Credit Policy
Credit policy adjustments often lead to changes in how quickly cash comes in. A tighter, stricter policy reduces accounts receivable and, in turn, frees up cash. That comes at a potential cost of lower net sales since buyers may shy away from a firm that has highly strict credit policies. Looser credit policies can have the opposite effect. As with many of these factors, there is a tradeoff to weigh.
Accounts Payable Payment Period
Negotiating a longer accounts payable period with your suppliers frees up cash because you have more time to pay your bills.The downside is that a supplier might increase prices in response to allowing a longer payment period. Shortening your accounts payable period can have the opposite effect, so business owners should carefully manage this policy.
Collection Policy
If you’re seeking to increase cash, a tighter collection policy could help. Cash comes in sooner (and total accounts receivable shrinks) when there is a short window within which customers can hold off on paying. A less aggressive collection policy has the opposite impact.
Growth Rate
Stronger growth calls for greater investment in accounts receivable and inventory, which uses up cash. This, in turn, leads to major changes in working capital from one month to the next. A slower growth rate can reduce changes in working capital.
Inventory Planning
Inventory decisions are a crucial factor that can lead to a change in working capital. If a company chooses to spend more on inventory to increase its fulfillment rate, it will use up more cash. Reducing inventory has the opposite effect.
Purchasing Practices
A change in purchasing practices can also lead to changes in working capital. If the purchasing department opts to buy larger quantities at one time, it can lower unit prices. However, it means a higher outlay of cash. Buying in smaller amounts can have the opposite effect.
Hedging
Using hedging strategies to offset swings in cash flow can mitigate unexpected changes in working capital. However, there are some costs involved in these hedging transactions, which could affect cash flow.
What Impacts Can Various Changes in Working Capital Have?
Change in working capital is the change in the net working capital of the company from one accounting period to the next. This will happen when either current assets or current liabilities increase or decrease in value.
Change in net working capital is an important indicator of a company’s financial performance and liquidity over time. By calculating the change in working capital, you can better understand your company’s capital cycle and strategize ways to reduce it, either by collecting receivables sooner or, possibly, by delaying accounts payable.
Understanding changes in cash flow is also important if you are applying for a small business loan. Lenders will often look closely at a potential borrower’s working capital and change in working capital from quarter-to-quarter or year-to-year.
Positive Impacts
If the change in working capital is positive, then the change in current liabilities has increased more than the current assets. This means the company’s liquidity is increasing.
Negative Impacts
If the change in working capital is negative, it means that the change in the current operating assets has increased higher than the current operating liabilities. Cash has been used, and this reduces liquidity.
Calculating Change in Working Capital
The change in working capital formula is straightforward once you know your balance sheet. Simply take current assets and subtract current liabilities. That difference is your working capital (WC). Next, compare the firm’s working capital in the current period and subtract the working capital amount from the previous period. That difference is the change in working capital.
Change in WC = Current year WC – Last year WC
How to Calculate Changes in Net Working Capital
As an example, let’s say in 2022 your working capital was $75,000. In 2021, your working capital decreased to $50,000. Using the formula above, we have:
Change in WC = $75,000 – $50,000 = $25,000
You can then use this figure to compare net working capital for your business over the years and track what is causing the changes. This allows you to make adjustments in your business, as necessary.
Why Calculating Changes in Working Capital Is Important
As a small business owner, monitoring and understanding changes in working capital over time, whether it’s quarter-over-quarter or year-over-year, can help you better understand your company’s cash flow.
Working capital is also important if you are trying to woo an investor or get approved for a small business loan. Lenders and investors will often look at both working capital and changes in working capital to assess a company’s financial health. Wide swings from positive to negative working capital can offer clues about a company’s business practices. A business owner can often access more attractive small business loan rates and terms when the firm has a consistent working capital policy.
The Takeaway
Working capital is a basic accounting formula (current assets minus current liabilities) business owners use to determine their short-term financial health. Changes in working capital can occur when either current assets or current liabilities increase or decrease in value.
As a business owner, it’s important to calculate working capital and changes in working capital from one accounting period to another to clearly assess your company’s operational efficiency. This is especially important if you are in the market for financing. Lenders will often look at changes in working capital when assessing a company’s management style and operational efficiency.
This article originally appeared on SoFi.comand was syndicated by MediaFeed.org.
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8 fool-proof ways anyone can pay off debt
Kerri H. asks, “I have about $20,000 in credit card debt and want to know if it’s better to pay it off using a home equity line of credit or a loan from my 401(k)?”
I appreciate your question, Kerri! This show will answer it by reviewing eight of the best methods to pay off debt and their pros and cons. You’ll learn how to evaluate different options and know which one is best for you in the long run.
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Hello, friends, and thanks for joining me this week! I’m Laura Adams, a money expert and author who’s been hosting the Money Girl podcast since 2008, with over 40 million downloads. My mission is to help you get the knowledge and motivation to prioritize your finances, build wealth, and have more security and less stress.
If you’re not already subscribed to the podcast, that’s the best way to ensure you never miss a weekly episode. Also, I love getting your questions on our voicemail line at 302-364-0308. You can also email me using my contact page at LauraDAdams.com.
Using debt wisely comes down to understanding the difference between good and bad debt and the right amounts based on your income and goals. Laura reviews how eight ways to know if you have too much debt and simple action steps to protect your finances.
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Before I cover ways to pay off debt, I want to review the differences between good and bad debt. While you might think all debt is bad, some can actually improve your finances. So, identifying your good and bad debt should help you know which ones to tackle first. Then we’ll review various debt payoff methods.
One way to know if a debt is good or bad is whether it pays for something likely to appreciate or depreciate. If you use debt to finance an asset that increases in value and boosts your net worth, it’s typically good. But going into debt for something that loses value or deflates your net worth is terrible.
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For instance, a home mortgage allows you to buy real estate that typically appreciates over the long term. While there’s no guarantee that a home will be worth more in five years than today, real estate generally appreciates about 3% to 5% per year and could be higher in desirable areas.
QUICK TIP: Use a Mortgage Affordability Calculator to know how much home you can afford before shopping.
Another example of a good debt is an education loan. While a student loan isn’t backed by an asset, such as a home, it can help you earn more over your lifetime. A college degree is required for many jobs and industries, such as health care, law, and computer engineering. So, depending on the career you want, taking out a reasonable amount of education debt can make you more employable.
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As I mentioned, bad debt finances something that loses value over time. For example, an auto loan allows you to buy a new vehicle, which typically depreciates by 50% within a few years. Of course, the depreciation rate depends on a vehicle’s age, make and model, and how well you maintain it.
While a car loan is technically bad debt, many people need vehicles for their businesses, jobs, or everyday chores. So it’s wise to borrow as little as possible or finance cars that hold their value over time.
Credit cards are one of the worst debts because they charge some of the highest interest rates and typically get used for consumer goods. Kerri owes $20,000 and didn’t mention the card’s interest rate—but let’s say it’s 18% APR. If you only paid the monthly minimum, it would take over fifteen years to pay off, and you’d fork over an additional $12,000 in interest! And the stuff you charged would likely be worth pennies on the dollar.
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Now that you know the difference between good and bad debt, what’s the best way to pay off your top-priority debts? There are three popular methods I’ll review.
But first, I recommend making a list of your debts, their interest rates, and balances. You might jot them down on paper or create a spreadsheet or Google sheet. Identify your good debts, such as mortgages and student loans, and your bad debts, like high-rate credit cards, personal loans, and auto loans.
Then you can prioritize them according to one of the following methods.
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You pay off debts in order of the smallest to largest balances, no matter their interest rates. For instance, if you have a $1,000 student loan balance at 5% and $2,500 on a credit card charging 18%, you might opt to wipe out the student loan first. That can motivate you to stay disciplined and eliminate your more significant debts.
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You pay off debts from the highest to the lowest interest rate. For instance, in my previous example, you’d pay off the 18% credit card balance before the 5% student loan because it costs you more in interest. I really like this method because it’s the most cost-effective in the long run. Plus, if you plow the savings back into your debt balance, you can reduce it faster.
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You pay off debts in order of newest to oldest. This method can help you improve your credit while you reduce your debt. For instance, if you got a student loan after opening a credit card, you’d pay off the loan first. That boosts your credit because more weight is given to activity on newer accounts than older ones. Raising your credit scores might be vital if you’re recovering from financial hardship or considering a big purchase like home ownership.
Consolidating credit card debt comes with several pros and cons, depending on the details. Money Girl’s Laura Adams details whether you should take out a personal loan to pay off a credit card and the long-term effect on your credit scores.
While these are common elimination strategies, there isn’t a right or wrong way to pay off debt. Any method you can stick with and make steady progress will be a good one.
Once you get rid of bad debts, you can consider tackling the good ones—unless you have a better use for your money. For instance, if you can invest money for a higher rate of return than a debt’s interest rate, you’re usually better off investing.
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Using a consolidation strategy can save money if you have one or more unsecured debts, such as medical bills, personal loans, student loans, or credit cards, you want to pay off faster. Debt consolidation doesn’t reduce the debt you owe, but transferring or reorganizing it can reduce your interest rate and make it easier to pay off.
Here are five ways you may be able to consolidate debt and pay less interest.
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You move unsecured debt to a new or existing credit card with a 0% APR promotion that may last up to 18 months. Every transfer is subject to a fee, such as 3% or 4%, which gets added to your balance.
Once a transfer promotion ends, your interest rate increases and could be very high. Therefore, it works best when you’re sure you can pay off the entire balance before the promotion expires.
Avoiding interest during a balance transfer promotion can save a chunk of change. However, the amount you can transfer to a card depends on the credit line the issuer offers you. If you don’t have good credit, you may not get approved for a balance transfer or be able to only put a small amount of your debt on a card.
Use a comparison site like Finder to shop for the best balance transfer cards with the lowest interest, transfer, and annual fees. Choose an offer where you come out ahead, even accounting for the transfer fee.
Ever wonder if using a balance transfer credit card could help you get out of debt faster? Laura answers that question and more on episode 733 of the Money Girl podcast.
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You use a new fixed-rate personal loan to pay off higher-rate unsecured debt. You make monthly payments during a set repayment term, such as three or five years. The rate and terms a personal loan lender offers usually depend on factors like your income and credit.
Remember that even though a personal loan may cut your interest, the shorter your repayment schedule, the higher your monthly payments will be. You risk hurting your credit if you can’t repay a personal loan as agreed.
You can enter basic information at LendingPoint to see your loan options without hurting your credit. It’s a good option when you have a larger balance to consolidate and want a structured repayment term.
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If you’re a homeowner with at least 20% equity, you may qualify for a home equity line of credit (HELOC). Equity is the value of your property, less what you owe for it.
For example, if your home’s market value is $400,000 and your outstanding mortgage balance is $300,000, you have $100,000 in equity or 25% ($100,000 / $400,000 = 0.25).
A HELOC is a revolving line of credit that allows you to borrow an amount up to your credit line, using your home as collateral, without needing to refinance an existing mortgage.
Since a HELOC is a secured debt, it typically has a much lower interest rate than a credit card or personal loan. You can use it in any way, such as for home renovations or paying off higher-rate debt. However, if you use HELOC funds to buy, build, or improve your home, a portion of the interest paid is tax-deductible—but that’s not the case for other uses like debt consolidation.
Like a credit card, you must make minimum monthly payments on a HELOC. Most have a variable rate, which means your payments can increase if interest rates rise. Another downside is that the lender can foreclose on your home if you can’t repay a HELOC.
Shop around for the best HELOC rate with the lowest fees. Your current mortgage lender may be able to expedite your application using paperwork from your original loan, depending on how long ago you got your first mortgage.
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Homeowners with at least 20% equity may qualify for a home equity loan. Like a HELOC, it uses your home as collateral without having to refinance an existing mortgage. But instead of a variable-rate credit line, it gives you a lump-sum amount to be repaid over a set term, such as from 5 to 30 years, at a fixed interest rate.
Like a HELOC, home equity loans generally have lower interest rates than unsecured debt. And you can use it any way you like, but a portion of interest is tax-deductible when you spend it to buy, build, or improve your home.
The main downside of tapping your home equity with a line of credit or loan is that if you default, you risk losing your home to foreclosure. Plus, there are closing costs, similar to a primary mortgage, which add to the cost of borrowing. Again, consider getting multiple quotes, including from your current mortgage lender.
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If you have a workplace retirement account or are self-employed with a solo 401(k), most plans allow you to take out loans with a five-year repayment term. Note that loans are never an option with any type of IRA.
While you must repay retirement loans with interest, it’s typically relatively low and goes back into your account. In addition, there’s no credit check, underwriting requirement, or fees since you’re borrowing your own money. You can borrow 50% of your vested balance or $50,000, whichever is less.
You can use a 401(k) loan for any reason, including paying off high-interest debt. But remember that borrowed funds won’t get invested in the market during repayment, which could jeopardize your retirement.
Another consideration is that a retirement loan must be repaid in full within 60 days if you leave your job or get terminated. If you didn’t repay it on time, it would be considered an early withdrawal, subject to income taxes plus a 10% penalty if you’re younger than 59.5.
In episode 770 of the Money Girl podcast, Laura answers a listener’s question about 401(k) loans and using them to pay off credit card debt. She covers 11 pros and cons of taking a loan from a workplace retirement plan, such as a 401(k) or 403(b).
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Now that we reviewed the most common strategies for paying off and consolidating debt, let’s get back to Kerri’s question: Is it better to pay off $20,000 in credit card debt using a HELOC or a 401(k) loan?
Kerri, as always, there are pros and cons for both. On the one hand, a HELOC gives you much flexibility to spend any way you like but requires a lender application, origination fee, credit check, and sometimes, an appraisal to verify your home’s market value.
On the other hand, a 401(k) loan has no formal application or fees but leaves you with less invested, and it could be costly if you separate from your employer for any reason and can’t repay the entire balance right away.
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My top recommendation is buckling down and paying off your card debt without borrowing any money. Ideally, you’d stop making charges you can’t pay in full monthly and create a $20,000 payoff plan. For instance, you could pay $3,333 monthly for six months or $1,666 for 12 months and wipe it out. If you have multiple cards, you could attack them using a snowball, avalanche, or landslide approach.
However, consolidating is likely worthwhile if you genuinely believe you can’t pay off your card(s) within a year. The danger is that after wiping out your balance, you’d continue racking up more card debt. So, be sure you’re committed to staying out of credit card debt.
Kerri, without knowing more about your financial situation, I’d lean toward the HELOC if I had to choose between a HELOC and a 401(k) loan. I believe a retirement account should only be tapped as a last resort. Your retirement funds are too precious to squander, and the potential penalties are too costly.
This article originally appeared on QuickandDirtyTips.com and was syndicated by MediaFeed.org.
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