What is Working Capital?
It’s safe to say that all businesses have one thing is common: To increase revenue year after year. The financial scenario of each business, however, is by no means cookie-cutter and requires a unique strategy in order to achieve such a goal.
So, what exactly is working capital?
Simply put, working capital is the cash needed to effectively run a business. To calculate working capital, simply subtract the total liabilities from total assets and you’ll get a good idea of where your finances stand.
Why is Working Capital Important?
Working capital is a daily necessity for businesses, since they regularly require cash for day-to-day expenses, payroll, bills along with other business needs.
Available working capital directly correlates with efficiency, liquidity and overall health of a business. It is a direct reflection of revenue, debt, inventory and payments to suppliers and vendors.
Therefore, working capital is a necessity of a firm's operational efficiency. Having enough working capital will keep your doors open and your business out of any financial trouble. Lack of working capital can bring long-term negative effects.
So, how can you monitor this? First, keep an eye on company finances on a regular basis. Catch any potential problems before they get worse and make the necessary positive changes.
Calculating working capital accurately measures your firm's short-term liquidity which is vital in cash flow management.
How do I Improve My Business's Working Capital?
Each business manages working capital differently. One strategy that may work for a dentist office may not work for the local personal training studio.
No matter your business, remember your goal is to show a working capital ratio of 2:1.
1. Manage Payments Efficiently
Collecting receivables on time can be a challenge. A marketing agency might ask for net 15, which means total payment must be made within 15 days from project completion. On the other hand, the most common term is net 30, which gives the business 30 days to pay in full.
You can also encourage customers to pay early by incentivizing them with “2% 10, net 30.” This simply means that if paid back within 10 days of the invoice going out, they will receive a 2% discount.
2. Manage Expenses
Is there a dedicated resource that analyzes fixed and variable costs? It’s important to know where your financial situation stands at all times. Certain expenses can actually be reduced by doing research and comparing vendors before making any financial decisions.
Working capital management is a good option when you don’t have the resources in house to manage expenses effectively.
3. Do Your Homework
Understanding all of your available financial options in the event you must take out debt is crucial. For example; options such as equipment leases can be a windfall for businesses who have opportunities to grow but are short on capital.
Equipment leases or loans can improve working capital by lowering your initial down payment on equipment and making your monthly costs more manageable. Also, you can take advantage of tax opportunities offered by Section 179 of the IRS Tax code. Be sure to discuss this with your accountant to ensure that you are taking all of the tax breaks available.
Fortunately, if you find your business is experiencing low or even negative working capital, there are options such as working capital loans.
What is a Working Capital Loan?
A working capital loan helps businesses carry out their day to day activities. While you cannot use these loans to purchase long-term assets, such as equipment (with the exception of merchant capital, which has no restrictions), there are many other benefits of working capital loans.
Working capital loans typically help to finance short-term liabilities. However, they are not always short-term loans. They can also be:
1. SBA Loans
While they are not the easiest for a small business to qualify for, they do present great value. With lower APR rates, SBA loans are one of the smartest ways to fund your business.
2. Invoice Financing
With invoice financing, you can borrow money based on what your customers owe your business. As the name indicates, lenders will purchase your outstanding invoices at a discount in order to provide you the funds you need right away.
3. Business Line of Credit
A business line of credit is a flexible loan that aids in short-term working capital needs. This type of loans helps with inventory purchases, future project costs, or company payroll. For as long as it is open, a business owner may draw down on it for whatever needs they choose.
4. Merchant Capital
Merchant capital is a lump sum of cash that is advanced to the business in need. Based on the average sales the business has done in the last month, this is both the fastest and easiest option for securing additional working capital. As a bonus, good credit is not required: since this type of loan is weighted more heavily towards a business's performance, credit scores are not scrutinized as much as they would be in the case of a traditional loan. The borrower then pays back the loan over a predetermined period of time at a fixed rate.
When is a Working Capital Loan Beneficial?
What happens when you’re running low on the capital required to order inventory? Or what if you’re waiting on receivables and are therefore unable to pay your staff? Many business owners rely on these short-term loans to keep business flowing.
Working Capital Loan: An Example
You’re in retail; custom dresses to be exact.
You have $6,000 of assets available. Remember, this includes any outstanding invoices, your cash that is it sitting in the bank, inventory, etc. And your liabilities equal out to $2,500. This is your debt, such as payroll expenses, rent, taxes, etc.
This means you have $3,500 in working capital. While that is more than enough to purchase your regular orders, what happens during prom season when many groups of girls will be coming in to try on new dresses?
This is where a working capital loan comes in handy. Simply borrow the money needed to cover the larger order to ensure that you have enough inventory in stock. Even with interest involved, you’d still be making a much larger profit than if you couldn’t fund the order in the first place.
Advantages of a Working Capital Loan
It’s not uncommon for a business to have trouble managing cash flow. With so many variables coming in and out of a given business on a daily basis, it can appear overwhelming. With the help of a working capital loan, you’re able to flexibly control your finances. Here’s how they can benefit your company:
Growth can be hard to predict, and long-term debt can have unsettling control over a business. Sudden financial changes (either positively or negatively) can impact future operations. You can utilize a working capital loan to fund any short-term expenses that arise from these fluctuations.
Borrow and Payback Quickly
Working capital loans are meant to be paid back more quickly than other forms of debt. They are almost always acquired to help with short term debts, thus they are typically returned in 4-18 months.
No Rules on How to Spend the Money
There is a very slim chance that your lender will place any rules on how to spend your loan. This is beneficial as you’re free to use the money as you see fit, not how anyone else wishes you’d spend the money.
Collateral Is Not Required
Business loans can either be secured or unsecured. Working capital loans are generally an unsecured business loan which means that with good credit history, you will not be required to put up collateral in return for the loan.
Will Not Compromise Ownership
Unlike other business loans out there, working capital loans do not require you to give up any ownership of your business. All you have to do is pay back the loan within the allotted time period.
Understanding Working Capital Management
By now, you should have a good understanding of working capital and the importance it has on running a successful business. By definition, working capital management is the way a business manages the relationship between liabilities and assets to ensure healthy cash flow.
With working capital management, you’re responsible for monitoring and reviewing assets and liabilities. If you have efficient working capital management, you can be assured of a smooth operation and improved profitability.
If your business lacks enough working capital to fulfill its obligation, you could be in trouble. But investing in an effective system will help avoid such situations. You wouldn’t want to put the business in risk of failure, right?
It does not only help your business in fulfilling its obligations but also helps it to boost its earnings. Managing your working capital means maintaining your cash flow, inventories, accounts payables and accounts receivables.
The Bottom Line
Working capital plays a huge part in running a successful business. Make sure that someone is appointed to manage such factors. Understand where your working capital stands, how to calculate it on a regular basis, and the importance of managing such funds. By following the steps in this article, you’re setting your business up for success.