Capital is business-speak for money, and working capital is the money available to fund a business’s daily operations – essentially, what you have to work with. Basically, working capital is a company’s liabilities, such as accounts payable, minus its current assets, such as accounts receivable and inventory. It is the lifeblood of every business, regardless of industry or size, and it is the ultimate indicator of a company’s short-term health.
Why is Working Capital for Small Business Important?
The amount of working capital a company carries for its daily operations is often seen as a measure of efficiency and short-term financial health. Positive net working capital indicates that company operations generate enough revenue to pay for its obligations with current assets. A very large working capital indicates that your company can fund its own expansion without taking on additional debt or investors. Without this money, your retail boutique, bakery, technology services, or other company will struggle to meet demands and pay its bills.
How to Calculate Working Capital
On the surface, determining this capital is not very difficult. In its most literal sense, the equation is:
Net Working Capital = Current Assets - Current Liabilities
However, accurately calculating this is often a challenge for businesses. And even so, the effectiveness of a small business’s working capital can be highly nuanced, being influenced by several factors such as:
- The types of current assets and how quickly they can be converted to cash - If the majority of your company’s assets are cash or easily converted to cash, you may be able to operate smoothly on a smaller amount of working capital than if those assets are slow-moving inventory items.
- The nature of the company's sales and how customers pay - Consistent, immediate payments for goods and services are generally more beneficial to your daily operations than when your credit terms are longer.
- The existence of an approved credit line and no borrowing - Having an approved credit line offers greater flexibility in the working capital for small businesses.
- How accounting principles are applied - This is mostly related to how a business’s accounting allows for doubtful accounts, that is, clients that are likely to default in payments.
Businesses that are highly seasonal or cyclical tend to need more working capital requirements than year-round businesses. This is because debts still need to be repaid even during the off-season, which means that more assets need to be reserved to keep the business afloat during these times.
How Can You Obtain More Capital?
As I’ve stated, maintaining a healthy working capital is vital to an operation’s success. If your operation is running low on working capital, you might be wondering what you can do to remedy the situation. There are a few options:
Working Capital Loans - These fall into several subcategories:
a. SBA Loans - These often have the lowest rates and longest terms of any working capital options, making their monthly responsibility very affordable. The favorable terms of these loans is due to the fact that the Small Business Administration (SBA) guarantees that it will pay the lender up to 85% of the loan should the business owner default. The SBA itself doesn’t supply these loans. Instead, these loans are issued by banks, community development organizations, and micro-lending institutions. Beware, fund disbursement usually takes 1-3 months after approval with these types of loans.
b. Short-term Online Loans - This option for raising working capital for small businesses is best for those who need immediate working capital and can pay back the loan in less than 1 year.
- Invoice factoring - This is a good option for businesses with unpaid invoices that are due in the next 30, 60, or 90 days and who need to fund a short-term cash infusion.
- Crowdfunding - A popular option for raising cash, crowdfunding sites such as GoFundMe and Kickstarter have been utilized to fund many a startup venture. A well-designed crowdfunding campaign can reach wide audiences and give your business a well-needed cash infusion.
- Peer-to-Peer Business Loans - This option is available to businesses with a strong credit profile looking for working capital to fund rapid business expansion with better rates and terms than short-term lending.
When considering the working capital for small businesses, a critical accounting principle to remember is working capital turnover ratio.
Working Capital Turnover Ratio
The working capital turnover ratio, also referred to as net sales to working capital, indicates a business's effectiveness in using its working capital. The equation for calculating working capital turnover ratio during a twelve month period is:
net annual sales ÷ average amount of working capital
An extremely high working capital turnover ratio can indicate that a company does not have enough capital to support its sales growth. A high working capital turnover ratio can be a strong indicator that the business is lacking the money it needs to support a growth in sales and that it may even be unable to pay its bills as they come due. When this occurs, the collapse of the business may be just around the corner.
Whether or not a company’s turnover ratio is excessively high can be determined by comparing it to other similar businesses in the same industry.
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