Excellent accounting to help small business owners.

Enforce Internal Control

What is internal control?

Internal control is vital in business to protect the company from mistakes and frauds. A business will not be able to survive in the end or grow if internal control not enforced. Every business needs internal control, as any company is business targeted for theft. Suppliers intentionally ship fewer goods than in the order; shoplifters are there to take your stock away with them when they walk from the shop. Unfortunately, some owners do not realize all this until it happens. They also do not understand that these can stop by introducing proper accounting systems. These internal controls specially designed to minimize errors in bookkeeping that stop the fraud by the employees.

Examples of internal control

· The business requires a second signature for cash withdrawals from the bank.

· Checking and matching the supplier's invoices with the order and the goods received before making the payment.

· the manager and a high-level authority should approve writing off the bad debts

· Stock control – An employee or an auditor is doing surprise counts of the stock in the company warehouse and match with inventory records.

· Require mandatory leave for the person doing the books that include the bookkeepers and accountants. Another person with accounting knowledge allowed doing the same work. Therefore that work helps in finding the irregularities in the company policy.

Many small businesses believe that they secured because trusted people run their business. However, it is no harm in enforcing internal controls in the event of fraud. Doing the daily balancing and checking to avoid the practice of dishonesty.

Complete with period - end procedures.

If all the transactions entered correctly, you are ready for the preparation of the financial statements. However, you have to do some more work to get prepared. For example, your equipment in your business needs to depreciate and the values included in the final accounts. Further calculations for accruals, prepayments also get involved in the reports. Final accounting work required to arrive at the accuracy of the statements for the period that required for the company.

How to implement financial control in a business?

Profit & Loss forecast

The profit and loss forecast is a projection of the sales and expenses that might occur during a specified period. If you say in a pure form, that is the forecast for the money that you receive and what your pay out, which most businesses heavily rely upon when managing their business.

The details of the forecast depend on the size of your business. Even the smallest business needs this detail, and depending on mental calculation is undesirable for the company.

Having a clear idea of the amount of working capital from the profit and loss forecast helps you to make decisions in the growth of your business. If the forecast shows that cash is available, it will be advisable to invest in items that are useful to your business development.

When you have done your profit and loss forecast, follow the contents in the document you prepared and taking quick actions to help to reduce risks in the business. On the other hand, it is also useful to develop your business like increase sales, the productivity of the bestselling items, and encourage more repeat sales.

Cash flow forecast

Cash flow can suppress your business. If you do not know, how much cash is going out and coming in, there is no control over the money in your industry. Ultimately, it can kill your business. Most businesses fail due to cash flow problems; because the customers do not pay on time, and you overspend on unnecessary things.

There few things need to check when you manage your business as it will affect your cash flow:

• You need to check your cash flow statement regularly.

• Receive payments from customers by the deadline for payments.

• Stop ordering stocks not required for immediate sales.

• Cut down the overtime for staff.

• Try and make the sales on cash

• Reduce credit sales.

Benefits of having a profit and loss forecast

• You will find it easy to assess your tax obligations.

• Useful to obtain loans or grants

• Credit agreements from potential suppliers.

• You need to invest in another business or expand your business.

  
  

A profit and loss forecast consists of estimated turnover, direct costs, and indirect costs.

Business plan

Then the business plan essential with these documents because that required for a business loan, grant applications, and any investors to learn about your business. Business plan document used for reference when you have trouble in your business because did in detail all the possible precautions. A business plan includes all about your business, marketing plan, financial, and operating procedure.

These documents are vital for any business to avoid the pitfalls and prepare yourself to meet the setbacks in your industry. A delay happens to any company at any time.

Therefore, when you think about enforcing financial control, first prepare cash flow forecast, profit and loss forecast, and the business plan. However, remember to revise those documents regularly. If not, it becomes outdated as the business grows or about to sink. Then you will be able to safeguard your business from problems.

How to find Working capital finance?

A capital used in day-to –day operations of the business. It is the balance from the current assets minus the current liabilities.

Shortage of working capital creates Cash flow problem in the business.

There are two ways to find the working capital for your business, factoring and discounting your invoices. When you run a business, you might have credit customers and have to wait for the payments of your invoices. That gives you a cash flow problem because you have weekly paid workers to run your business. Even if your business is making a good profit that does not mean that, your cash flow is reliable. It not uncommon for the business owners to find this problem all the time. As a new business owner, cannot have more cash in your bank account not possible. The cash flow issue might get better in the end but big problems at the start of any business. Therefore, you have to find ways of raising working capital to run your business smoothly.

How will you raise your working capital?

Are you going to look for a bank loan?

Are you going to use your credit cards?

It is not possible to get more loans as you would borrow money to set up your business. Therefore, the only other option is to go for discounting or factoring your invoices. Discounting invoices is not getting a loan but selling your invoices at a discounted price to a factoring company. This method will give you immediate cash to solve your cash flow problem. When you choose this method, you will have the control over your sales ledger and debt collection. It is possible only if you have human resources to manage your sales ledger and debt collection. If your company is small and short staffed the other, option is to do factoring your invoices. Here the lender will do the group and the credit control.

The benefits of factoring and discounting of invoices

· Cash flow problem solved

· Helps to grow your business

· The factoring company manages the credit control, and you have more time in developing your business.

· Funding secured without requiring other assets.

· Making prompt payment to suppliers will help you to get discounts.

· Useful for new businesses

· Helps in growing the business you can put the money back in business.

· Factoring and discounting offer competitive prices and excellent advisory service.

Invoice discounting

In this method, you will have control over your debtors. Therefore, you could maintain the confidentiality. That helps the stability of your business

Invoice factoring

Here the lender will have the complete control over your sales ledger the secrecy gets affected. As a result, your suppliers may become reluctant to give you support.

Final words.

There is risk involved in any business so factoring and discounting has risks. The lender has less control over the payments because it depends on the receipts. The lender has to receive the payments according to the agreed date or may not receive at all. For this reason, discounting done for big companies with sizeable creditworthy client base. However, factoring usually used by smaller companies as the lender has more control over the sales ledger. Therefore, it is up to you to choose which method suits you better. Nevertheless, in any business that gives long credit terms will have problems that can solve by factoring or discounting of invoices.

When a business starting from scratch might have a small amount of cash in the bank account of the company. However, while trading, the business might need some assets to run it efficiently. Therefore, the industry spends money on fixed assets such as land and buildings, machinery, and equipment called capital expenditure. The payment for these assets is from the original capital or the retained profits or surpluses as the business trades from year to year. It called capital expenditure.

Difference between revenue & capital expenses

Then any expenses made to improve these assets added to the same asset account that increases the book value of these assets. A budget created for the business cost of capital expenditure included in the budget, so it protects from overspending on capital investments.

Here is an example showing the machinery account:

All ilustrations  shown in the resources

Machinery account

At the end of the year, the balance of $5700 in the machinery account will show under the heading fixed assets in the balance sheet of the business.

Revenue expenditure

Revenue expenditure appears as a debit in the trading or profit and loss account at the end of the financial year.

Here is the illustration of how it appears in your books.

Revenue expenditure charged to that account as soon as the cost incurred. Expenses incurred in the administration of the business

Advertising

Example of revenue expenditure

Revenue expenditure refers to the cost of maintaining and operating these capital assets, including all repairs. It also embraces all the expenses of preserving sales revenue and all trading expenses. Such as payment of wages and salaries, materials bought for re-sale or conversion, advertising, insurance, heat & light, repairs, and transport; these are all debits found in the profit and loss or trading account.

Revenue expenditure

Debited and charged to the profit and loss account, reducing the gross profit to attain the net profit.

Capital expenditure

Capital expenses

Debited to asset accounts and taken to the balance sheet under the heading of fixed assets. It should charge to profit and loss account to decrease the profit.

What is the effect of capital and revenue expenditure in the final accounts?

What is a capital expenditure?

Profit calculation

The purchase of capital items like machinery, land & buildings, furniture, and fixture, and motor vehicles’ to use in the business either in the long run or for one or two years. The expenses incurred in this way called capital expenses.

Importance of capital expenditure.

It is better if you have a budget for capital expenditure as it protects you from losing financial benefits over the years. Capital expenses on an asset helping to grow the profit in the company over several years, which is longer than the current tax year. It differs from operational costs that paid for assets during the current year for use in the current tax year. An example of functional expenses is buying a printer, which is a capital expense. Always capital expenditure is much higher than the other costs, mostly because it is a long-term asset.

The sole proprietor of the business needs to make the budget for capital expenditure as it has long-term effects on the finance side of the company.

Revenue Expenditure.

An expense incurs in the accounting period to support the current operations of the business.

Revenue expenditure is the sum of the expense that the business incurs in the production of goods and services, which helps for revenue generation of the company in an accounting period.

The following are examples of revenue expenditure

Rent

Rates

Electricity

Salaries

Manufacturing expenses

Transport

Printing

Traveling

More:

An item of revenue expenditure is the cost of payments incurred for the running of the business. It is the cash spent on generating sales or maintaining a revenue-generating asset. As an example, a piece of machinery is asset cash spent on purchasing that asset is capital expenditure and payment spent on maintaining that motor like regular cleaning is a revenue expenditure. Therefore, the money spent on sales generation and maintenance of assets refers to revenue expenditure.

Revenue expenditure is the expenditure incurred by the company during its ordinary course of business operations for which the benefit will receive in the same accounting period in which committed and shown as the expense in the income statement of the company.

How do these expenses appear in the final accounts?

Capital expenditures charged to expense in the long term through depreciation and the revenue expenditure charged as expenses during that accounting period.

The accounting entries will be as follows:

Capital expenditure

Debit Assets

Credit Cash/ Payables

Revenue expenditure

Debit Revenue expenses in the income statement

Credit Cash/Payables

Revenue expenses end up as a debit to the trading account or the profit and loss account at the end of a financial year.

Business accounting

Money received from the sale of a capital asset debited to the cash account and credited to the debit of the particular, which sold. The cash amount received from this type of sales not treated as sales income or takings, and the value of that asset needs to erase from accounting records. If the particular was subject depreciation, the specific documents need adjustment as that individual asset not there for a discount.

I hope above tips are useful for a sole trader when marinating the books for capita and revenue expenses related to the business.

How to make a ledger account?

The ledger is the official record of a company’s accounts, and sometimes we refer to the general ledger, purchase ledger, sales ledger, and cashbook. A ledger provides all accounting transaction entrees and gives the balance for a specified period. At the end of the period, ledgers serve as an authoritative source of data building for financial statements of a period. Therefore, the accounting means a master record of all the financial affairs of a company.

A ledger account contains a record of business transactions. A separate file within the general ledger that assigned to a specific asset, liability, equity item, revenue type, or expense type.

Cashbook

Examples of ledger accounts are:

· Cash

· Accounts receivable

· Accounts payable

· Accrued expenses

· Debt

· Salaries & wages

· Office expenses

· Depreciation

· Office administration

· Cost of goods sold

· Revenue

Information stored in a ledger account with the ending and starting balances for a period and adjusted with debits and credits. Individual transactions identified within a ledger account with a transaction number or other representation so that one can research the reason why a deal entered into a ledger account. Transactions caused by regular business activity, such as billing customers or recording supplier invoices, or they may involve adjusting entries, which call for the use of journal entries.

The information in a ledger account summarized into the account-level totals shown in the trial balance report, which in turn used to compile financial statements.

The ledger account may take the form of an electronic record if an accounting software package used, or a page in a written ledger, if the accounting records kept by hand. The general ledger also called as a nominal ledger

As an example posting from the sales daybook to the sales ledger, debit the personal account in the sales ledger and credit sales account in the nominal ledger. Then the other postings from the purchase day ledger done the same way mentioned in the sales daybook.

Accounting for inventory

Learning about inventory is essential for any business who sell products because need to buy to sell goods and important to have a counts of the items that you hold in your business if not you might run or over stock the goods.

Inventory means that the goods bought for sales to the customers or to use in the manufacturing of the products. It reported as the current assets in the balance sheet of a company. Too much

Inventory account

2 Dec $

Purchases 400

2 Jan $

Sales 400

Inventory can create cash flow problems because you have used too much to buy the inventory. Here in the above illustration you might think it is easy to account for the sale items that you have in your stock, but when making the sale need to have profit, so the sales figure is more that the cost of the stock.

When the profit and loss account done, the cost of goods sold taken away from the sales gives you the gross profit. When the cost of goods sold calculated to deduct from the sales, the additional expenses incurred in buying the inventory added to the cost of goods sold.

There are four accounts involved in the inventory

Purchase

Sales

Returns inwards

Returns outwards

Let us assume a business is buying a book for $100 and the shipping cost for that is $5.00 and recorded in the inventory account. In addition, when the business sells the book the amount will be $105, which removed from the inventory account

Inventory generally categorised as raw materials, work in progress, finished goods, raw materials are unprocessed goods used to produce a good.

Cost of goods sold

Cost of goods sold to customers and reported on the profit and loss accounts when the income revenue reported. Total revenue taken off the cost of goods sold gives you the gross profit for a certain period.

Accounting Transactions

When preparing monthly or quarterly income statements, the amount of revenue recorded at the top of the income statement. Cost of goods sold then subtracted to show gross profit. When you sell goods, you recognize the reduction in inventory as well. If your accounting method shows a $20,000 COGS and your prior inventory level was $100,000, your new inventory balance would be $80,000. When you acquire new inventory, you add the costs of acquisition to the value of inventory.

Purchases of inventory

When a company purchase inventory making an immediate payment of cash or it buy on credit terms the necessary accounting entries shown below.

In cash sales the immediate payment occurs so an asset increased- bank balance

However, in credit sales payment receive later therefore an asset increased that is the debtor as we debit debtor.

Then there will be returns of inventory outwards and inwards, so the accounting entries made in the asset account

All the illustatrtions will be in the resourcess boox

Accounting

A control account used to check the accuracy of the postings to a particular ledger account. The term self-balancing refers to the inclusion of a control account generally kept at the front or back of the ledger and used by the accounting staff on the total balances extracted from that ledger. In addition to the check the work of the bookkeeper, also this system used for internal audit purposes.

Control accounts are general ledger accounts that summarise a large number of transactions. As such, they are part of the double-entry system. They used to prove the accuracy of the ledger accounting system. They used primarily concerning receivables and payables balances

The common types of control accounts are accounts receivable and account payable. Accounts receivable usually maintained for when you sell goods on credit that are for the amount due from debtors. In the same way, the accounts payable is the amount that you owe to your suppliers. You can also use a stock control account that use to summarise the transaction in the inventory and stock.

Sales ledger

When you sell goods, you will raise the invoices for your records. Those invoices entered in the sales ledger as a debit entry, and when you receive payments from the customer, you will credit the sales ledger and debit the bank account. Thereby it will show that there is no outstanding debt owed to you. If you have not received the money when you are, closing the report for that month, the balance on the sales ledger will show as a debtors control account. The balance on the debtor’s control account will add to the assets account in the balance sheet

Purchase Ledger

When purchases made by the business receives invoices and those recorded in books called purchase ledger. Companies maintain a double-entry system unless it is a tiny business. Therefore, the debit entry entered the purchase ledger, thereby cancelling the original credit entry when the invoice received from the supplier. If you have not made the payment by the end of the month, the balance on the purchase ledger will show as a credit balance on the creditor’s control accounts. That balance added to the liabilities in the balance sheet.

The purpose of the control account is to keep the general ledger nice and clean without any details, yet contain the correct balances to use in the financial statements. Many of the reports seen in the financial statements take cash, for instance, shown as the control account in the balance sheet.

accounts payable, accounts receivable, Control accounts, purchase ledger, Sales ledger

Equity means the owners interest in the business, and it referred to as assets minus the liabilities. The balance in the capital increases when more capital introduced and the company makes a profit. Whereas the amount in the capital account decreased when withdrawals made and if the company make a loss. In the case of a small business, a single capital account is set up known as the owner’s capital account. In a sole proprietorship when cash or assets taken by the owner, it is classified as the drawings and decreases the capital account.

What is the use of control accounts?

One of the main benefits of constructing control accounts it can help to restrict errors. It saves time as the location of any errors takes a considerable and takes more time to find the errors after extracting the trial balance.

The total of all the trade receivables should be equal to the control account in the sales ledger as all the data entered into both accounts at the same time. The data consists of the amount receivable from the credit customers of the company. In addition, if it does not balance it shows there an error made in entering the transactions.

But there could be mistakes even after constructing control accounts are the following

An entry missed out completely

An incorrect amount recorded in both accounts.

Transactions recorded in the wrong personal account.

The main limitation in the use of the control accounts is the inability to detect these errors.

Prevention of fraud

If one person does the double entry bookkeeping and another person oversees the control accounts the possibility of making fraud by employees becomes difficult.

It is because the control accounts acts as a heck and highlight the difference for example if the receipt not entered in a personal account.

Incomplete records

If a business does not have a complete set of data, the control accounts can help to determine the missing data. I there no data for sales ledger constructing the control accounts can be helpful to find the missing data.

Advantage of using control accounts.

The principal advantage of using the control accounts to reduce the need to deal with many sales, or purchase ledger balance to a singles sales or purchase ledger balances. Therefore, the interim and final accounts can draw up more quickly.

Sub dividing a ledger means easier to find errors because each division is self – contained in double entry terms.

See illustration for sales ledger control account in resources

The sales ledger balance was £1006 and found the following errors

Sales invoice for £120 missed out

A bad debt of £65.00 recorded in the sales ledger missed out.

The total balances of trade receivables over stated by £50.00

Return inwards was £31 but recorded as £13

See the illustration for the updated sales ledger control account and Reconciliation of the trade receivable accounts is as follows to show the correction of errors.

Costing & Pricing a product or service

Costing itself a separate subject, as there many different methods to allocating costs to business activities. Charging is the expenses incurred in the production of a product or in providing a service. The price the amount the customer is willing to pay. The cost incurred to produce a product has a direct impact on pricing and the profit earned by the company. There is a well-known tendency for the small owners to under-price the item, as they believe in having more sales. However, they do not realize that it is risky to under-price as the business might face a substantial loss.

For budgeting and accounting purposes, it is essential to classify the costs appropriately. It is vital to have a proper understanding of direct and indirect costs, as you need to use that for correct pricing. When you know the exact costs, easy to price your product competitively and accurately, it also becomes easier to implement better practices and explain to the investors. Some of these costs are tax-deductible when filing your accounts.

The terms used in accounting for costs are:

Direct cost

It is the cost involved in producing the product or service. Direct costs include

Direct labour

Direct materials

Manufacturing supplies

Wages tied to production

Variable costs.

These costs can vary depending on the number of units produced, such as manufacturing for the purchase of materials, wages of employees directly involved in the production, transport costs. It also depends on the quantity of the goods produced for example packaging is variable costs, therefore; it depends on the number of packages done

Indirect costs

These costs not directly related to production. Some incidental damages might be overheads. Indirect costs refer to the director’s salary, electricity allocated to production, transport, distribution costs, shipping and postage, and some more.

Fixed costs

These costs incurred regardless of the sales, which means if you sell a product or not cost incurred. For example, these are costs for rent, rates, and wages for employees, depreciation, owner’s salary, and drawings.

Usually, in the service industry, the owner’s time not adequately accounted for and neglected; therefore, it should be there to record owner’s time to include in the cost of the service that you deliver.

Pricing

Before considering pricing, you have to know the market for your product well and research the comparison. Then decide whether you are going to be at the same level or to increase the price more than your competitor’s price. However, one thing it is dangerous to be on the same level without checking your direct and indirect costs into account. Nevertheless, make sure the customer will pay the price that you set for your product.

Then you have to know the value that the customer attached to your products; in other words, the market value for your product. Maybe you have made a mistake with the costs of producing your product. You cannot overprice your product.

Do not undercharge your product or service, even if you are desperate to make enough sales. If you are the service provider and new to the industry will tend to undercharge. Then also, if you realize your mistake, you will not be able to go back to the customer and claim the real value for your service.

You will be safer to do market research in checking prices before setting the price. Then when you set the price, keep an additional percentage for your profit and arrive at the sales price. However, do not rush and offer discounts because you need more sales. In case of a bulk order even, do not give a refund but provide some other facilities like free delivery.

Then pricing also depends on the location; therefore, you need to know the price in your area before finalizing your price setting.

Accounting for Bad debts

Bad debts expense relates to accounts receivable; these expenses are doubtful payments from the customers. Even in a prosperous economy, business failure is a common thing, and businesses will be unable to pay the amounts that they owe; in recession, bad debts will be more, and we should have a way of accounting for it. Therefore, the evil results when the goods or services sold on credit the customer became unable to pay the amount that they owed.

Accounting records for bad debts

Bad debts is an expense and so that is a debit and the credit goes to accounts receivable

Debit- Bad debt account

Credit- Accounts Receivable.

When selling goods or services on credit, you might have two things

• Your company will face an increase in sales that brings in a higher profit for your company.

• If your customer does not pay for the invoice that issued, you will suffer losses, and the company runs at a loss.

When the sales increase, the sales revenue reported on the income statement — moreover, the unpaid invoices taken as the asset in the balance under debtors.

When the customer does not pay, the bad debt expense shown in the income statement and the lousy debt reduces the income receivable shown in the balance sheet.

In addition, in the trial balance, the balance for debtors (Accounts receivable) should show after subtracting the amount for bad debts. However, the information comes into effect after finalizing the trial balance the figure for debtors calculated deducting the bad liabilities.

Provision for bad debts.

If you want to manage smartly, the amount of money owed to you depends on the actual amount receivable from your customers. Therefore, an assumption made to take a certain percentage as bad debts before including the figure in the financial statements. It called provision for bad debts. That is, you are setting an amount that you might not receive from customers.

The Accounting entries for provision for bad debts accounts

All arrangements for bad debts are credit entries. A company naturally estimates its bad debts depending on its historical experience and charge this expense as a debit to the wrong debt expense account (which goes as a debit to the income statement) and credit the provision for bad debts accounts (appears in the balance sheet). An organization should make these entries in the same period, and then revenues matched with applicable expenses

Example showing the entries

Year      Debtors as at 31 December         Size of provision made 5%

2010               $3000                                                   $150

2011                $6000                                                   $300

Provision for doubtful debts

In 2010, the full amount of provision for doubtful debts debited to statement of financial accounts, as there are no provisions made in the previous year and the balance carried forward for next year.

In 2011, the provision increased due to the increase in debtors, but only the increase debited to financial statements.

Bad debt recovery

Sometimes if we are lucky enough, the amount written off as the bad debt we recover for some reason. Therefore, the accounting entry for the improvement is as follows.

Find the relavant illustrations in the resources section.

What is working capital?

Working capital is the difference between a company's current assets and current liabilities. It is a financial measure, which calculates whether a company has enough liquid assets to pay its bills that will be due within a year. When a company has excess current assets, it can use that amount to spend on its day-to-day operations.

Current assets

1. Cash and equivalents,

2. Inventory,

3. Accounts receivable,

4. Marketable securities

They use these to convert into cash within a year.

Current liabilities – The amount of money that company owes.

1. Accounts payable

2. Short-term loans

3. Accrued expenses,

Those are due for payment within a year.

What is the Working Capital Formula? -The working capital formula is:

Working Capital = Current Assets – Current Liabilities

The working capital formula is short-term assets like cash, accounts receivable, and inventories after paying off the short-term liabilities like accounts payable, short-term loans, and accrued liabilities. Therefore, the short–term liquidity helps the company manage the cash flow to perform financial analysis and then to financial modeling. Below is an example balance sheet used to calculate working capital.

Current assets

$

Cash

10000

Accounts receivable

5000

Inventory

7500

Total

22500

Current Labilities

$

Accounts payable

8000

Short-term borrowings

3500

Accrued liabilities

7000

Total

19000

That results in the business is having positive working capital of $22500-19000= $3500

When your sales increase, the company's working capital increases; for example, if your product price is $800.00 and your cost per unit is $600.00, the difference between the two is $200 that increases for every item you sell in your business. So, your cash increases for the cash sale, or the accounts receivable will increase when you sell on credit.

Can build your working capital in this way so you can spend more money on developing the company when compared to your competitors

Positive working capital

Enough liquid assets to pay short-term bills

Internally finance the growth of its business

Able to manage cash flow well.

Negative working capital

Borrow additional funds from a bank

Investment bankers to ask for more money

Face liquidity crises

Negative working capital will lead to more borrowing, unable to make payments to suppliers and creditors that means the company will face a lower credit rating.

When negative working capital is ok

Depending on the type of business, companies can have negative working capital and still do well. Examples are grocery stores like Walmart or fast-food chains like McDonald's that can generate cash very quickly due to high inventory turnover rates and receive payment from customers in a few days. These companies need little working capital to be kept on hand, as they can generate more quickly.

Working capital is the basic necessity for any business. The business requires cash to make payments, cover unexpected costs, and purchase some money to buy products to use in the production of goods. Management of working capital includes management of accounts receivable, accounts payable, and inventory management.

Adjustments to the working capital formula

While the above formula and example are the most standard definition of working capital, there are other more focused definitions.

Examples of alternative formulas:

• Current Assets – Cash – Current Liabilities (excludes cash)

• Accounts Receivable + Inventory – Accounts Payable (this represents only the "core" accounts that makeup working capital in the day-to-day operations of the business)

Ratios to Watch

When you divide your current assets by your current liabilities, you get a number representing your company's relative financial health. That's your working capital ratio.

Current Assets/Current Liabilities = Working Capital Ratio

For example, $200,000/$150,000 = 1.33

You want a working capital ratio between 1.2-2. That means that you have ample cash to pay your debts, but not too much, just sitting around doing nothing.

A ratio below 1 means you have negative working capital and struggle to stay current with your debts.

A ratio above 2 means you have lots of extra cash that you could be reinvesting in the company and are not. If you have extra cash, you're not making smart choices about your money.