A Guide to Working Capital
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Working capital is the money you use to cover all your short-term financial obligations. It’s essential in the daily operations of a small business. A proper understanding of working capital keeps your business running smoothly and sets you up for growth.
What is Working Capital?
Working capital is the money you have on hand to fund your daily operations. It could consist of money you’ve saved from sales, the proceeds of a bank loan, or other forms of capital you’ve raised (such as an owner’s investment). Small business owners use working capital to cover daily and monthly expenses like payroll, rent, and utilities.
How do you Calculate Working Capital?
Working capital is a simple formula calculated off your Balance Sheet. Take current assets and subtract current liabilities to get working capital.
Because working capital measures your ability to fund day to day activities, you should only take current assets and liabilities. If you tried to convert a fixed asset, such as selling a truck or large piece of machinery, to cover rent it would probably take too long for you to receive the funds. And you’re not worried about paying long-term liabilities on a daily basis.
Current assets include: cash and cash equivalents, accounts receivable, and inventory. Current liabilities include: accounts payable, accrued liabilities, payroll expenses, and any short-term debt.
While the Balance Sheet fluctuates less than the Income Statement, items can move from long-term to short-term categories. For example, a long-term loan could move up into current liabilities as it gets closer to coming due.
Why Do You Need Working Capital?
Working capital is important because it helps you identify a potential cash flow crunch.
The working capital ratio helps you determine if you can cover your short-term liabilities. The working capital ratio, or current assets divided by current liabilities, tells you how many times your current assets could cover your current liabilities. A ratio of less than one is a warning sign that you could run into financial difficulties at the end of the month when current liabilities come due.
This measure of liquidity indicates if you can meet funding obligations or need to borrow to cover any gaps in the short-term. While it’s most often used as a quick measure of liquidity, it’s also useful to monitor over months or years.
Why is Working Capital Important Long-Term?
Tracking the working capital ratio over time enables small business owners to spot potential worrisome trends. If the ratio has been steadily declining over several months, take a closer look at your business’ operations.
Maybe creditors are taking too long to pay, and your accounting department has lagged on collections. Perhaps sales have slumped, or costs have risen but you haven’t adjusted prices. Measuring the long-term performance of working capital ratios can prove useful to small business owners.
How to Address Negative Working Capital
What if you are having issues maintaining a positive working capital ratio? Address it as soon as possible, preferably before some of those current liabilities come due.
1. Speed up collections
Delays in getting paid lengthen your working capital cycle. If customers are taking 90 days to pay, but your bills are due in 30 days, you’ll have a 60-day cycle. Shortening that cycle improves your working capital ratio and cash flow.
Take a good look at your A/R Aging report and focus on collections from customers in the 90+ and 180+ days past due bucket. Consider offering a small discount to customers who pay within 30 or 60 days, and penalizing late payers with interest charges and late fees. Shortening the time between invoicing and payment improves your working capital.
2. Request deposits on work
Another way to improve working capital is to request that customers pay a deposit on work. A deposit gives you a cushion to cover expenses during the time you start and complete work.
This is particularly necessary in industries such as construction where you will have to lay out cash for materials and supplies before even beginning work. But even service-based businesses might benefit from requesting a retainer from clients.
3. Look into working capital loans, invoice financing, or a merchant cash advance
If collections have become an issue, investigate invoice financing. With invoice financing, you sell your outstanding receivables to a third party. They advance the cash you need and you pay interest against the invoice’s values.
Working capital loans can be another great way to ensure you have adequate working capital to operate your business. There are a wide variety of resources for this type of funding that can be found online in a few clicks.
A merchant cash advance is another option if your business has a volume of credit card receivables. With a merchant cash advance, the lender evaluates the past few month’s credit card sales and advances you a sum of money based on their predictions for the future. They take their repayment as a percentage of future credit card sales.
With both of these options you’re working with a third-party lender who gives you the working capital you need to meet current liabilities.
4. Request extended payment terms
Another way to manage a negative working capital ratio is to address the denominator – or current liabilities owed. Extending payment terms on your current liabilities can buy you some breathing room. Talk to your lenders about extending payment terms, ask your landlord for a rent extension, or negotiate with vendors for 90 or 120 days to pay on invoices due.
Top Reasons You Might Need More Working Capital
Failing to have enough working capital in your accounts can put your business’ continued operations in jeopardy. There are two main reasons you might need to take out a working capital loan:
1. To keep your business running when cash flow slows. For example, if you run a seasonal business and have marked slower periods for sales but rent still comes due.
2. To fund growth or big projects. For example, if you’re starting a large project for a client who refuses to put down a deposit, you need capital to keep you going until it’s completed and you’re paid. Without working capital, the project could fail.
3. To take advantage of supplier discounts. Sometimes suppliers offer discounts to buy in bulk, or if you prepay for shipments. If you have extra working capital, you can take advantage of these deals and save money.
Working Capital Mistakes to Avoid
Small business owners should avoid these mistakes when managing their working capital.
1. Opening a Large Line of Credit You Don’t Need
It’s easy to fall into the trap of thinking that keeping a large line of credit open means you’ll never have to worry about working capital again. But, even if you never draw on the line of credit, you’ll pay fees to keep it open. Often, lenders based those fees on the line of credit’s maximum borrowing limit.
Work with an accountant or financial advisor to determine the appropriate size line of credit to open before applying with a lender. Over-financing your business can negatively impact your operations.
2. Paying Hidden Fees
Read the fine print on any line of credit, merchant cash advance, or invoice financing loan that you’re considering. Many charge hidden fees, like subscription or inactivity fees, that can add up.
3. Financing New Customers with Revenue from Old Ones
Small business owners who use the revenue from an old customer to finance a new customer’s project will quickly run into working capital issues. When your last job pays you, but you haven’t received a deposit on your next job, using that payment for project-related costs for the second customer is a bad idea. Those funds should go to working capital needs like rent or payroll.
Small Business Owners and Working Capital
Learning to effectively manage your working capital doesn’t just keep your doors open – it can help you grow and build for success. Take the time to learn about it and implement some of these strategies and feel the weight of cash flow issues lift from your shoulders.