Even the most successful businesses struggle to keep up with daily operational costs while seeking sustainability and growth, both of which require working capital.
Working capital is essential to successfully evolve and maintain a business. Owners need enough working capital to account for emergencies, cash outflows, and opportunities when they arise. Whether it’s expansion, seasonal demand, new technology, or hiring employees, having available capital makes all the difference in business’ success.
WHAT IS WORKING CAPITAL?
Working capital is the amount of liquid assets your company has available. To calculate this, take the value of current assets (cash, accounts receivable) and subtract the current liabilities (accounts payable, accrued expenses).
Funds go out to cover business expenses and working capital keeps the operation running.
An easier way to think about it is the accessible assets available between the days a business pays for things and when the business has new income.
It’s possible to improve your working capital by making adjustments that shorten the accounts receivable collection time, keeping accounts payable low, and shortening the amount of time allotted to debtors.
However, most businesses cannot finance their operating cycle with accounts payable financing alone. This shortfall typically needs to be covered by the net profits generated initially or by external funding.
Filling In the Gap
One important factor for any small business is planning ahead. Your business might go through experiences where there’s a need for short-term working capital. Getting caught off guard can cost you a major client or important sales opportunity.
Four financing options that offer businesses short-term working capital financing are:
A Business Line of Credit:
If your business is well capitalized by equity and has good collateral, it has a high chance to qualify for a line of credit provided by a bank. This line of credit allows you to borrow funds for short-term financing. With a business line of credit, you don’t start paying any money back until you draw from the funds. As you pay the money back, the amount available returns to the initial funds. In order to obtain a business line of credit, your business needs to have exceptional credit scores and a track history of success.
Benefits of A Business Line of Credit:
- Fast access to money
- Generous credit limits
- Easy money transfer
Small Business Credit Cards:
A small business credit card is a beneficial tool to use for more flexible working capital. Getting a small business credit card with cash back rewards is a great way to cut costs and earn money while spending money on everyday business expenses. Using a credit card for your business sends positive card activity to the business credit reporting bureaus. As long as you keep your credit utilization low and maintain other good financial habits, you’ll be able to qualify for more rewarding cards and financing in the future.
Benefits of a Small Business Credit Card:
- Merchandise discounts
- Purchase protection
- Points or cash back expenses
Merchant Cash Advances:
You can obtain cash advances against your business’ future credit card sales. The lender then collects a set percentage of your credit card sales everyday until your advance is paid off. You don’t need to put up collateral for a merchant line of credit, but your business needs a well established credit profile to show your ability to pay them back.
Advantages of Merchant Advances:
- High approval rating
- No collateral is at stake
- Your credit won’t be affected
Alternative Lending:
Alternative lending is the overarching term for small business financing options outside traditional banks. The Small Business Administration shows that only 1 out of 10 businesses are getting approved for financing from their bank, so private lending services have become a popular funding option. Whereas big banks have an approval rating between 13% and 20% over the past 5 years, alternative lenders have accepted on average between 61% and 64% of small business owners looking for funding. Fill out a free application online for alternative lending with FundKite here.
Perks of Alternative Lending:
- Less paperwork
- More flexibility
- Faster funding
Lessons
Remember, the shorter the working capital cycle, the more effective a company’s working capital is. The longer the working capital cycle, the more time a company’s capital is tied up without earning returns. Small businesses should always strive to reduce their working capital cycle to increase their available liquid assets. Additionally, companies should always monitor their working capital ratio to ensure that they are investing excess assets whenever possible.
This guest post was written by Courteney Reed, a financial industry analyst dedicated to empowering people to make smart financial decisions.
How to Calculate Working Capital
Calculating working capital is a fundamental aspect of assessing a company’s financial health and liquidity. To calculate working capital, use the following formula:
Working Capital = Current Assets – Current Liabilities
- Current Assets include cash, accounts receivable, inventory, and other assets expected to be converted into cash within one year.
- Current Liabilities encompass short-term obligations like accounts payable, short-term debt, and other debts due within one year.
Working capital provides insights into a company’s ability to cover short-term liabilities with its short-term assets. A positive working capital indicates liquidity, while a negative working capital may signal potential financial challenges.
1. Significance of Working Capital Management: Effective working capital management is crucial for several reasons:
- Liquidity: Adequate working capital ensures a company can meet its short-term financial obligations promptly, maintaining financial stability.
- Operations: It supports day-to-day operations by funding expenses like payroll, utility bills, and inventory purchases.
- Growth: Proper management facilitates business growth by providing resources for investment in assets, expansion, or seizing new opportunities.
- Creditworthiness: Lenders and investors often assess working capital to gauge a company’s ability to repay debt and manage its finances responsibly.
- Risk Mitigation: Maintaining a healthy working capital buffer helps mitigate unexpected financial shocks or economic downturns.
Companies must strike a balance between optimizing working capital to support growth and ensuring they have enough liquidity to cover obligations.
Factors Affecting Working Capital
Several factors influence a company’s working capital:
- Seasonality: Businesses with seasonal sales may experience fluctuations in working capital throughout the year.
- Industry: The type of industry can impact working capital needs, with capital-intensive industries requiring more investment.
- Credit Policies: A company’s credit terms with customers and suppliers can affect accounts receivable and accounts payable, directly impacting working capital.
- Efficiency: Efficient inventory management and collection of accounts receivable can enhance working capital.
- Economic Conditions: Economic downturns can strain working capital as sales may decrease, and customers may delay payments.
- Capital Investments: Expanding or upgrading fixed assets can tie up capital, affecting working capital.
- Debt Management: Servicing debt obligations affects cash flows and working capital.
Understanding these factors allows businesses to make informed decisions to optimize their working capital, ensuring financial stability and growth.
