When embarking on a career in franchising, it’s important to understand critical business terms. In this article, we’re explaining what it means when someone refers to “working capital.”
To define working capital, you should first understand your company’s current liabilities. Current liabilities can be described as your business’ short-term financial obligations, representing your “must-pay” monetary responsibilities. They can include things like payments to suppliers and other short-term financial commitments. Understanding your current liabilities can help you manage your cash flow and ensure that your immediate financial obligations are met.
Now, working capital is the ability for a business owner to pay those current liabilities using their current assets. You can think of it as the money you have on hand to maintain your daily operations.
Having enough working capital is key to running your franchise, as you want to avoid causing any hiccups. However, it’s important to strike a balance between working capital and generating profit, and it can take some careful consideration to maintain it. For instance, overinvesting in working capital can hurt your finances overall. Plus, saving up on working capital can be detrimental if you’re already losing money. On the other hand, insufficient working capital could hinder your business’s growth. For example, if you don’t maintain adequate inventory levels, you could miss sales opportunities.
How to Calculate Working Capital
So, you understand that working capital is important, but how do you calculate it so you’re maintaining the right amount for your franchise business? The easiest way is to subtract your current liabilities from your current assets.
Step one should be determining your current assets, which are the assets you can quickly convert into cash within one year prior or one business cycle (whichever is shorter). Finding this number requires maintaining updated, organized financials as a franchise business owner.
What is the Working Capital Ratio?
Determining the working capital ratio, also known as the current ratio, can also be helpful. This ratio tells you the amount of working capital that can be used to cover each dollar of current liabilities. To produce this ratio,divide your current assets by your current liabilities.
If you receive a low or negative ratio number, it can indicate your current assets are not large enough to cover your liabilities. So, what should the magic ratio be? If your calculations show 1.5 to 2, your business can be considered in good financial health. The higher the number, the greater your chance of paying your current liabilities. However, you can have too much of a good thing—a high ratio may indicate you have too much cash on hand and are not distributing your assets well enough to areas that could benefit your franchise business.
Calculating Working Capital Turnover Ratio
While we’re on the topic of generating working capital, determining your working capital turnover ratio can also be important to know as a business owner. Working capital turnover tells you how effectively you use your working capital by looking at how your business generates sales for every dollar of working capital used. To find this out, take your net sales in a certain period, such as in a year, and divide it by your working capital in that same period. Like current ratios, you should hit a working capital turnover ratio of 1.5 to 2, as anything less than 1 could indicate some concerns and may need to seek where they can save.
Financial Guidance Through Franchising
There are several benefits to franchising, one of them being the expert support and guidance supplied by the franchisor to the franchisee. As a franchise business owner, you have a business model to follow that has proven to be effective. This provides a map to help generate revenue and maintain sufficient working capital, aided by the brand recognition and customer base you get from being in the network.
If you are interested in taking the next step in your career, franchising with The UPS Store may be right for you. Check out our benefits page and FAQ page for more details.
