Do you know the difference between working capital and cash flow? Many people mistakenly assume these terms are interchangeable, but they have two different meanings.
Understanding them is essential for anyone who wants to truly understand his or her business.
A Guide to Capital
Working capital is an overall calculation of your company’s operating money less your debts. While it does include the amount of cash your business has, capital also accounts for the value of other assets, such as your business equipment, inventory or other investments. When it comes to debt, capital calculations account for short-term and long-term debt, including deferred revenue, accounts payable and other expenses. The calculations allow you to compare your assets to your liability over a specific period of time.
Calculating Capital
You can calculate capital in two ways. The current ratio method is the baseline for your capital and shows your ability to pay your obligations. To find it, calculate each of your assets (everything your company owns) and your liabilities (every debt you owe). Divide the assets by the liabilities. If your answer is one or higher, you have a good current ratio. You might also try the acid test ratio method. Also known as a quick ratio, this method involves measuring short-term, liquid assets against liabilities. It does not include inventory and only focuses on assets that you can turn into cash in 90 or fewer days. To calculate it, subtract your inventory from your current assets and then divide just like you would with the current ratio method. Again, one or higher is considered a good answer.
How Capital Differs From Cash Flow
The only real difference between capital and cash flow is the calculation. Capital focuses on a broader financial picture for your company, but cash flow only considers your income and expenses. Cash flow focuses only on a set period and determines how much money you bring in compared to how much you pay out. Capital shows you whether you can pay off debts immediately.
How They Affect Each Other
Working capital helps would-be financers determine if your company is a worthy investment. Negative capital means you’re not likely to be a good investment unless you have a very positive cash flow. Keep in mind that borrowing increases cash flow but does not improve capital. In fact, borrowing makes capital look worse since you’ll need to show the debt repayment. Keep this in mind before borrowing from any financer.
