Working capital can assist you in growing your business or taking advantage of larger projects.
Working capital covers your daily operating expenses, funds larger projects, and can keep you afloat even in the most difficult of times.
We’ll go over everything you need to know about working capital so you can survive tough economic times and capitalize on big opportunities when they arise.
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What Exactly Is Working Capital?
Working capital is the money you have on hand, whether it is from profit, a bank loan, or another source of capital. Equity capital is used to fund your day-to-day operations, pay rent and employees, and cover other operating expenses.
Working capital is simply the funds available to cover your short-term expenses.
GROSS WORKING CAPITAL VS. NET WORKING CAPITAL
You may have also come across the phrase net working capital. Net working capital is the difference between your balance sheet’s current assets and current liabilities. It measures your company’s liquidity and ability to meet short-term obligations while also funding business operations.
You should ideally have more current assets than current liabilities. This results in a positive net working capital.
You can also compute and evaluate gross working capital. This is the total of all your assets that can be converted to cash within a year.
Because gross working capital does not account for liabilities, net working capital provides a more accurate picture of where your company stands. As a result, when we say “working capital” in this article, we mean net working capital.
When Will You Require Working Capital?
To pay the bills, pay your employees, keep your cash flow strong, and ultimately stay solvent, your business requires a certain amount of working capital.
However, you may require additional working capital at different times. This is where knowing how to calculate your working capital comes in handy. For example, you may require additional working capital:
- To keep your company running when cash flow is slow. Assume you own a seasonal business, such as a lawn care service. If you live in a northern climate, the majority of your business will take place in the spring and summer. During that time, you may need to hire more people or purchase more equipment. And, during the off-season, when revenue is lower, you may have to account for higher expenses. Another scenario that could impact cash flow and necessitate more working capital is an economic slowdown.
- To finance expansion or large projects. When working on a project-by-project basis, you must account for ebbs and flows in your cash flow. For example, when you begin a large project that will pay upon completion, you will require capital to keep you going in the interim.
So, how do you begin calculating you are what is working capital?
How to Determine Working Capital
The working capital formula is straightforward:
Current assets are cash and assets that can be converted into cash within a year (fixed assets are considered long-term assets on your balance sheet). Accounts receivable, inventory, and short-term investments are examples of these assets.
Current liabilities are short-term liabilities (debts or accounts) that must be settled within a year, such as accounts payable, overdrafts, sales tax, payroll expenses, and wages.
You should aim to have more current assets than liabilities or positive working capital to ensure positive short-term financial health. If current assets do not exceed current liabilities, you have a deficit, may have cash flow issues, and may be unable to pay creditors.
Even a profitable business can face difficulties. Cash may be trapped in assets like debtors or raw materials, and the inability to convert them back into cash indicates a lack of liquidity.
But, even after you’ve calculated your business assets, how do you know what amount is appropriate? Take a look at the working capital ratio.
WHAT IS THE WORKING CAPITAL RATIO?
The ratio is a measure of your company’s financial health. The formula is as follows:
The ratio determines whether you have enough operating capital to cover your short-term liabilities, also known as debt. Anything less than one indicates a negative equity capital. Anything greater than 2 indicates that your company is not investing excess working capital and assets and has too much cash locked up in inventory, raw materials, or debtors.
A ratio of 1.2 to 2 is usually sufficient. A declining ratio over time could be a red flag that requires immediate action. It could, for example, indicate that your collections process is slow, which would be reflected in your accounts receivable.
Where Can I Get Working Capital? (or Address Negative Working Capital)
If you don’t have enough equity capital to cover your expenses, you’ll have to find some or risk project failure. You could get a bank loan, but the application process takes time, and approval isn’t guaranteed even then.
Finding funding elsewhere is the solution. Here are five quick ways to raise cash and get more working capital:
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FASTEN THE COLLECTION PROCESS
Working capital shortages are frequently caused by client payment delays. These delays will increase the length of your equity capital cycle. The time it takes to convert current assets and current liabilities into cash is referred to as your working capital cycle. A longer equity capital cycle means that money is trapped in current liabilities and current assets for a longer period of time.
For example, if you pay suppliers in 30 days but collect receivables in 90 days, your cycle will be 60 days. Your goal is to shorten the cycle and lower the amount owed in your accounts receivable. One way to accomplish this is to invest in solutions and strategies to expedite the collection process:
- Keep track of collection times with clients so you know who the slow payers are.
- Renegotiate payment terms with current clients to get them to pay you sooner.
- Invest in tools that will help you get paid faster to improve your invoicing procedures.
- Allow clients to pay easily by accepting their preferred payment method, such as credit cards. For example, FreshBooks accepts American Express, Mastercard, and Visa.
- Encourage prompt payment by rewarding and penalizing customers. Include a discount for early payment and late payment penalties in the form of an interest fee. However, make certain that you understand when it is appropriate to charge late payment fees.
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APPLY FOR A DEPOSIT
Nothing is more frustrating than a project coming to a halt due to a lack of funds. Requesting an up-front deposit provides you with business assets to cover project costs.
Deposits also reduce the likelihood of nonpayment. Clients can pay to your bank account if you request deposits via email.
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SUBMIT AN APPLICATION FOR SBA LOANS
SBA loans are loans that are guaranteed by the Small Business Administration. Instead of making these loans, the SBA mitigates the risks for banks by providing a guarantee.
These loans are ideal for companies that need long-term business assets. Although they provide a safety net for large projects, the approval process is time-consuming and strict requirements must be met:
You must have been in business for at least two years. To demonstrate your ability to repay the loan, you must have a credit score of at least 680.
3 Working Capital Red Flags
There are several lending practices to be aware of, as well as funding sources to avoid, that try to take advantage of a company’s business assets problems.
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BEWARE OF SECRET FEES
The advertised cost of the funding is frequently not the actual cost. Subscription and inactivity fees are common hidden fees charged by lenders. To avoid unexpected and often high fees, read the fine print and understand the actual cost.
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AVOID LARGE LINES OF CREDIT THAT YOU DO NOT REQUIRE.
Make sure you don’t overspend. Many businesses receive larger and larger lines of credit when they only require a small amount. Speak with your accountant, give them your balance sheet and other financials, and get professional advice on how large a line of credit you need and what the credit terms should be.
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AVOID FINANCING NEW CUSTOMERS WITH OLD CUSTOMERS’ REVENUE.
Many small business owners use past customer revenue to finance the next customer. If you do this frequently, you will quickly run into cash flow issues.
Working Capital Key Takeaways
Working capital is essential for day-to-day operations, funding business growth, and assisting you during difficult economic times.
That is why it is critical to understand what it is, how to calculate it using the business assets formula, and where to get funding.
How you go about it will be determined by your company’s needs. You may need to accelerate collection procedures, request a down payment, apply for a short or long-term loan, or use invoice financing.
Whatever you decide, you can rest easy knowing that you have enough working capital to grow during the good times and survive during the bad. Also, read about business loan interest rate.