What is Working Capital?
Working capital is defined by dictionary.com as “the amount of capital needed to carry on a business” or your “current assets minus current liabilities.”
By calculating your working capital, you are able to understand something much deeper: your liquidity. With this measurement, you can make fairly accurate assumptions on the efficiency and financial stability of your company (something every business owner can benefit from, small or large).
Why is working capital important to a business?
Besides the fact that understanding your working capital needs can provide you with great insight on your company’s financial health, strong working capital management can enable you to propel your business forward.
When you are able to maintain a certain level of working capital, you can not only successfully pay off your short term expenses and debts, but you can also pick and choose the right amount of money to set aside for investing in your future.
What is a lost opportunity cost?
As a business owner, you have to make frequent decisions about how to use finite resources. Any choice you make means diverting those resources in one direction instead of another. The choice to buy new equipment may mean you have less time to pay for additional employee training. The choice to take on one time-consuming project may come at the expense of taking on several important, but smaller, projects. Any decision, no matter how small, comes with some opportunity costs.
Imagine your company has the chance to make a large sale to a creditworthy customer. It would mean significant growth for your company, and it may lead to more sales of its size in the future. However, at the moment, you don’t have the working capital you’ll need to complete the sale. It would strain your resources to buy additional materials or pay for more employees, in addition to your existing costs, all before the customer pays you.
You could turn down the opportunity, losing out on the chance to realize growth for your business. Alternately, you can take on the opportunity by securing financing from your bank in the form of a loan or a line of credit.
How should I measure opportunity costs?
Whether you should decide to forgo the opportunity or secure financing to proceed with the opportunity depends on the potential profitability. If the amount the customer will pay is enough to cover the fixed and variable costs and the cost of financing the project, it might be a good opportunity. If it wouldn’t more than pay for all costs involved on your part, it’s probably not worth considering.
When weighing the value of a potential business opportunity, you should estimate financing cost in dollars, rather than percentage points (APR). Add this cost in dollars to the existing fixed and variable costs associated with the project. This will allow you to have a clearer picture of the potential value of this sale, or to quote the customer an appropriate amount so that you can turn a profit on the sale.
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