Disclaimer: I am not a financial advisor or accountant. This article is for informational purposes only. Please use the info at your discretion.
Investopedia says working capital is:
A measure of both a company's efficiency and its short-term financial health. The working capital is calculated as:
Working Capital = Current Assets - Current Liabilities
The working capital ratio (Current Assets/Current Liabilities) indicates whether a company has enough short term assets to cover its short term debt. Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient. Also known as "net working capital".
Does that mean almost nothing to you? Great. That means you’re in the right place.
What is working capital?
At the base level, working capital is your ability to keep your business running with the cash you have. It all comes down to the concept of cash flow management.
Think of it this way -
Let’s say you make just enough personal income each month to cover all your personal expenses and you don’t have any savings. You get paid every two weeks. If all of your theoretical expenses for the month (rent, groceries, utilities, everything) is due on the 1st of the month, you’re not going to be able to pay all your bills on time, because you only have half of your income for the month. This is a cash flow management problem - you don’t have enough cash to cover your short-term debts.
Working capital is simply a measure of a business’s current short-term cash management state. Essentially, it’s whether your business has enough “liquid” assets (cash, inventory, etc.) to cover current debts (bills, short-term debt, etc.).
Why is working capital important?
To figure out why working capital is important, let’s look at the formula for working capital ratio. As Investopedia said, the working capital ratio is determined by dividing current assets by current liabilities.
If you have a working capital ratio of less than 1, that means your business does not have enough short-term assets to cover your short-term debt. This means you’ll need an influx of cash (loans, personal investment, etc.) in order to keep your business going in the short-term.
However, a working capital ratio greater than 2 can be excessive because you generally don’t want to keep too much of your business’s cash in the bank. Instead you want to invest that money wisely in the business to make more money with it. An exception to this may be if your stockpiling cash until you can invest one lump sum back into the business (like if you’re moving into a building, for example).
According to Investopedia, between 1.2 - 2.0 for a working capital ratio is a sweet spot (though I've seen 2.0 is more desirable). Around that ratio, you should have enough cash to cover your short-term debts, but won’t have too much money frittering away in the bank.
Working capital is a completely relevant to managing your business. It’s essential that you have enough cash in order to keep your business afloat. But it’s also really important that you don’t stockpile too much cash. Excess cash back should be invested into your business in order to grow and serve the world better.
Remember, money is a tool. You rule it, it doesn’t rule you. Managing working capital is one important way to rule the money and manage your business effectively.
For more on working capital:
Working Capital by U.S. Small Business Administration
The Importance of Working Capital Management in Avoiding Bankruptcy by Will Gish (Chron)