Working Capital vs Cash Flow
At ForwardAI Predict, we understand that small business owners are always looking for ways to keep track of their company’s financial health. But it’s not always easy to know the difference between key measurements (accounting terms) like working capital and cash flows.
Each of these variables provides a different glimpse into your company’s finances. Working capital offers a snapshot of your company’s present ability to pay its most immediate debts, while cash flow projects all income and expenses over a specific period of time. Think of it as a macro and micro level of detail. Cash flow gives you the big picture of your inflows and outflows. Working capital zeros in further by analyzing your cash flow to ensure that you can meet your payment responsibilities.
Despite some similarities between working capital and cash flow, each tells a different story. Cash flow forecasting gives you the insights and analysis to examine both. In this article, we’ll take a closer look at how working capital differs from cash flow.
Working capital is the amount of operating money your company has after your debts are accounted for. This number not only includes the total amount of cash you have in hand. It also factors in the value of your equipment, investments, and inventory. In terms of debts, working capital factors in things like accrued expenses, accounts payable, short-term debt, deferred revenue, and the amount of long-term debt you may owe. Working capital compares assets and liabilities for the short-term, usually up to 1 year (12 months) at a time.
Here’s another way to understand working capital: Say a large segment of your company’s clients are affected by a natural disaster, delaying payment on current purchases and postponing additional near-term orders. Your bank loan is also due in full at the end of the month. Your customers are all busy responding to Mother Nature’s wrath and won’t have their own businesses back online come back for a few months. But, if you have working capital, you can cover this unforeseen cash flow hiccup with the funds you have at hand.
Current ratio (good ratio) and working capital
It’s easy to get a baseline understanding of your company’s working capital by way of its current ratio. The current ratio demonstrates your company’s ability to pay for its long- and short-term obligations by assessing its total assets versus its liabilities. You can calculate your current ratio by dividing current assets by current liabilities. A result of one or above is considered a “good” current ratio.
The calculation itself is simple, but it’s important to make sure you’re accounting for every asset and liability, as opposed to only a handful. Your assets are anything your company owns and could turn into cash within a year. Liabilities are every debt or expense that your business expects to pay within a year or a business cycle.
Calculating a current ratio: An example
For this example, Connor’s Contracting has $300,000 in current assets and $100,000 in liabilities.
Current ratio = current assets ÷ current liabilities
Current ratio = $300,000 ÷ $100,000
Current ratio = 3
As a ratio above 1 is desired, Connor’s Contracting’s current ratio of 3 shows that the company is in good standing and capable of repaying debts, even if it were to incur an unexpected dip in sales or unanticipated expense.
Quick ratio (acid test ratio) and working capital
The current ratio provides a looser method of determining your company’s working capital. The quick ratio, however, is a bit more conservative, as it measures your company’s short-term liquid assets against its current liabilities. The quick ratio does not include inventory in your calculations as it can be more challenging to turn existing inventory into cash on short notice.
This is where quick gets its name — this ratio is all about determining what your business owns that can be turned into cash quickly. (Think 90 days or less.) Most businesses have fewer assets that fit the bill in this case, which makes your quick ratio more stringent than its current ratio.
Calculating a quick ratio: An example
Back to Connor’s Contracting with $300,000 in current assets and $100,000 in liabilities. For this example, let’s say the business has $200,000 in inventory.
Quick Ratio = (Current assets – inventory) ÷ current liabilities
Quick Ratio = ($300,000 – $200,000) ÷ $100,000
Quick Ratio: 1
With inventory taken out of the equation, the picture for Connor’s Contracting looks a little different. When inventory isn’t counted as an asset, the business’s liquidly is less favorable than when inventory is included.
The differences between working capital and cash flow come down to calculations. Working capital takes a broad picture of your company’s overall holdings and debts to determine its ability to meet its financial obligations. Cash flow looks only at your income and expenditures. Granted, several components play a role in determining both working capital and cash flow, but the main difference between these two figures is their scope.
Cash flow reflects the amount of money that your business generates within a set period. Your cash flow shows you how much you’re bringing in, and how much money is flowing out. Cash flow also shows you how much money you have in hand to reinvest in your company.
Working capital demonstrates your ability to pay off immediate liabilities. Your working capital can (and will usually) fluctuate over time, but it’s not the kind of metric that you’d use to make future projections of your company’s solvency. Think of working capital as a more “just in time” way to evaluate whether or not your company is cash positive.
When working capital affects cash flow
Working capital does more than reflect your company’s current ability to pay off debt and sustain operations. It also helps creditors understand how a would-be borrower takes in revenue, spends its money, and whether or not it is likely to remain solvent in case of an emergency or market downturn.
You’re less equipped to deal with difficult times if your company operates with negative working capital. You may still have positive cash flow on a long-term basis, but you may not able to sustain your business operations if your cash flow dips. There are instances in which a business might be doing fine despite having negative working capital — usually, if it’s just made major investments in its own growth — but these kinds of examples are definitely the exception to the norm. Usually, insufficient working capital means that your cash flow is going to need to be much more positive than it would be otherwise.
Lenders are interested in how your company’s working capital and cash flow affect one another, too. In fact, they’ll likely make a decision on your loan request based on what they see. Borrowing money increases your cash flow, but not in a way that improves your working capital. You’ll see a short-term bump in the cash you have in hand, but you’ll have to reflect the debt repayment in your working capital evaluations. This could make lenders more reluctant to finance your business.
Putting all the pieces together
It’s just as important to understand your company’s working capital as it is to keep on top of its cash flow. A cash flow forecast from ForwardAI Predict provides you with detailed, near-real-time information on your company’s financials — including your current and quick ratios— along with other insightful analysis and breakdowns of your income and expenses. Your risk score, featured within the analysis dashboard, gives you an indication of how positively or negatively prospective lenders might view your business’ financial health.
Getting your report is as simple as creating an with ForwardAI Predict and connecting your QuickBooks Online account.
The information in this article is not financial advice and does not replace the expertise that comes from working with an accountant, bookkeeper or financial professional.
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