In this article, we’ll talk about working capital versus growth capital. What do the terms mean? What is the difference? Why should you care?
Working Capital is the difference between your current assets (on your balance sheet) and current liabilities. Current assets include, cash, accounts receivable & inventory. Current liabilities include accounts payable, notes payable & accruals. Working capital is a measure of your liquidity; your ability to pay your current obligations (bills) when due. The higher your working capital, measured in currency, the more comfortable your suppliers & lenders are because even when things don’t exactly go as planned you can still pay your bills.
A similar way to measure your liquidity is your current ratio which is current assets DIVIDED by current liabilities. The result is a proportion rather than currency amount, yet it still gives you a relative idea of your short-term financial position.
Growth capital, on the other hand, is the amount of long-term debt & equity on your balance sheet financing your future growth.
Working capital is important in the short-term. Growth capital is critical over the long-term. Both have to be managed properly for any organization to be financially stable.
Working capital can be measured anytime by looking at the upper portion of the balance sheet. The existing level of growth capital is calculated by looking at the lower right portion; long-term debt & equity. Based on your long-term plans, you may want to increase your growth capital This means either borrowing more long-term debt, selling more equity or a combination of the two.
Working capital measures the cash flow you generate to pay your current liabilities. Growth capital is repaid via profits.
You need to establish the levels of working capital you choose to maintain. This is tactical & can change at your discretion as circumstance, the economy and/or your industry changes. Minimizing Working Capital (considered aggressive in financial terms) allows you to reduce the level of current assets you need to carry, freeing up cash as you reduce them, yet increases the risk of you not being able to pay your bills when due. Maximizing working capital (the more conservative approach) reduces the risk of missing payments but locks up cash in illiquid assets like inventory & receivables.
The amount of growth capital you require is strategic: where do you want to take your organization over the long run & how much long-term debt & equity do you need to get there? Part of the answer to these questions can be found through using either the AFN (Additional Funding Needed) or EFN (External Funding Needed) models.
The more growth capital you have the faster you can grow, the more leverage you employ, the higher the risk of financial default & the higher the profits you need to generate to repay lenders while meeting the expected annual return of shareholders; with or without cash dividends. The lower your growth capital the slower you can grow but because of this there is a relatively lower risk of default.
Understanding your working capital needs help focus you on your short-term cash flows needs; sources & uses. Calculating your growth capital needs involves planning how you will grow & then calculating if that will generate the necessary level of profits required to repay everyone as needed.
Determining the right amount of both working & growth capital for your firm can make the difference between your sustainable success & your struggling to survive.
This article was written by Daniel Feiman, MBA, CMC®, Managing Director, Build It Backwards(SM). For further information on this & other related finance & strategy topics please visit www.BuildItBackwards.com