What Business Owners Need To Know About Working Capital

Working capital dictates the short-term financial health and operational efficiency of a company. It is the lifeblood of any business. This article describes key aspects of how to manage it, how to calculate it, and gives optimization strategies.

What Is Working Capital?

In simplest terms, working capital is how much liquidity your business has. People can also consider how much money your business has to invest in continuing its growth Also referred to as Net Working Capital (NWC), it's a metric that can help you understand your company's financial health and maximize your profits. In the business world, "working capital" is a term used to describe a company's money to pay for its day-to-day operations. In other words, it's the cash that a business has available to meet its short-term obligations.

#CaminoTip If you have bad working capital, your business might be in danger and you need to fix it ASAP. A financial institution can help you with that.

Putting your assets (e.g., inventory, accounts receivable) and liabilities (e.g., credit card debt) on paper is similar to getting a checkup with your physician. At a glance, you can see how healthy your business is financially speaking. Then, it's easier to adapt your working capital to accommodate seasonal upsurges during your business cycle. Some people also use working capital loans to improve this metric. Plus, you can determine in which areas you tend to overspend. You soon discover your business's financial health continually changes, which is normal.

Learn more about the importance of working capital.

What Is Working Capital Used For?

You can use working capital for the day-to-day operations of running a business.

• This includes paying off debts that are due soon, like the money you owe to suppliers or creditors.
• In addition, you can use it to buy inventory.
• It also allows you to buy products or raw materials to keep your business running.
• Furthermore, it helps pay for overhead costs such as utilities, rent, and salaries for employees.
• It's also used to invest in short-term opportunities that can lead to business growth.
• And also to remain competitive.

Working Capital Formula

Working Capital = Current Assets - Current Liabilities

Typical current assets are:

• cash
• accounts receivable
• inventory
• short-term investments

Typical current liabilities are:

• accounts payable
• accrued expenses and taxes
• customer deposits
• other trade debt

Some business owners also include the current portion of long-term debt in the liabilities section. This makes sense because it is a financial obligation. Also, many small business owners prefer to use their daily operating cycle to best determine their working capital needs, which is also perfectly acceptable. The operating cycle analyzes the accounts payable, inventory, and accounts receivable cycles in terms of days.

Example Of How To Calculate A Company's Working Capital

Meet Manuela. Manuela is the owner of a beauty salon. These are her current assets and liabilities: Current assets:

• Cash: $5,000
• Accounts Receivable: $2,000
• Inventory: $8,000

Current liabilities:

• Accounts Payable: $4,000
• Accrued Expenses: $2,000
• Other Trade Debt: $3,000

Manuela can use the formula above to calculate her working capital: $15,000 (total of current assets) - $9,000 (total of current liabilities) = $6,000 (working capital) Since Manuela's current assets exceed her current liabilities, her working capital is positive. This means that Manuela can pay all of her current liabilities using only current assets. In other words, her beauty salon has liquidity, and she has some extra capital to grow her business in different ways. If your business doesn't have enough working capital, though, you can get external financing to bridge the gap between your assets and liabilities. Apply For A Business Loan!

What Is The Working Capital Ratio?

The working capital ratio—also called the current ratio—is a liquidity ratio that measures a company's ability to pay off its current liabilities with current assets. With it, small business owners can understand how their business is doing. After all, it is well known that assets must exceed liabilities to realize a profit. If the margin between the two is too close, your business suffers.

What Is A Good Working Capital Ratio?

You can consider a good ratio anything between 1.2 and 2. By keeping tabs on this number, you can quickly assess whether you need to tweak your business plan or make other adjustments to cash flow.

Working Capital Ratio Formula

Working Capital Ratio = Current assets / Current liabilities #DidYouKnow You can also refer to “Current debts” as “Current liabilities.”

Example Of How To Calculate The Working Capital Ratio

Let's say your small business has $100,000 in current assets and $60,000 in current liabilities. Then you just simply calculate:

• Working Capital Ratio = $100,000 / $60,000 = 1.6

The Importance Of Working Capital

Working capital may seem like a simple idea, but it's really important for your business. Let's see why.

Liquidity Measurement

It tells you how much money you have at hand to cover your short-term costs. It provides stakeholders with insights into the company's:

• financial stability
• ability to grow without relying on outside financing

Operational Efficiency

Working capital also highlights a company's operational efficiency. A business with a consistently positive working capital means efficient management of:

• assets
• liabilities

This typically translates into sustainable business operations.

Risk Mitigation

A healthy working capital provides a safety net that allows a company to weather periods of uncertainty without resorting to drastic measures.

Things That Affect Your Working Capital

Upfront Payments

If a company requires customers to pay upfront for products or services, before delivery. This provides an influx of cash that you can use to pay short-term obligations. In other words, it improves working capital. By receiving a deposit or full payment upfront, you keep your finances on an even keel as you complete projects for your customers. Some business owners use this method with new clients since they haven't established a credit relationship. Moreover, these types of payments cover ongoing expenses. If your business provides an immediate service or product to your clients (think of a retail store, for example), you probably require an upfront payment from your clients.

Payment In 30 Days

Offering net-30 payment terms to customers means the company lets customers pay their invoices within 30 days. This creates receivables, which are assets, but it can reduce working capital in the short term until customers pay their invoices. For example, manufacturing companies and businesses in the labor-intensive construction industry normally set up a 30-day payment schedule with customers. As you complete work throughout the month for different customers, payments come in each week throughout the 30-day period. This boosts your cash flow and prevents you from borrowing money.

Available Cash

This refers to cash or cash equivalents on hand that are not restricted. Having high available cash means the company has the liquidity to pay expenses and debts as they come due. It directly improves working capital. For example, a consumer-focused industry like food and beverage keeps a close eye on the available cash. Many of these industries work with suppliers to extend payment beyond 30 days during upswings and downswings and keep inventories as lean as possible. Because the demand for products that consumers use regularly is high, it's possible to double annual revenue by focusing on strategic cash management.

7 Ways To Optimize Your Working Capital

1. Keep Your Inventory In Check

Inventory can be tricky to manage, especially for businesses operating in industries with fluctuating demands. Here's the trick, match your inventory with your sales forecast. This way, you free up money that could get stuck in unsold items. If a product or service isn't performing well, consider deleting and replacing them with ones that produce more revenue.

2. Streamlining Accounts Receivables

Your business' accounts receivables represent the credit you've extended to your customers. It's crucial to ensure a timely collection of these receivables to keep your cash flow steady. To keep your money flowing, you can:

• Offer discounts for early payments
• Follow up on late payments

3. Prudent Accounts Payable Management

Extending payment periods where possible can help manage your working capital. Negotiating better credit terms can free up cash in the short term. This way, you can hold onto your cash a bit longer without risking your relationships with suppliers.

4. Tightening Credit Policies

While extending credit can boost sales, it can also lead to an accumulation of receivables. Giving credit can boost sales, but it can also lead to a pile of unpaid bills. So, it's crucial to:

• Check your customers' creditworthiness before extending credit
• Only give credit to customers who are likely to pay on time

5. Regular Cash Flow Forecasting

Performing regular cash flow forecasts can help you anticipate future cash needs. This enables you to make informed decisions about:

• inventory purchasing
• credit extensions
• payment scheduling

6. Trim The Excess

This means looking closely at how you spend money and how to save money. For example, can you reduce vehicle, office, advertising, and staff expenses? Perhaps you could shop insurance costs or negotiate better pricing with suppliers. Lean management is a strategy all about producing more with less.

7. Make Debt Payment A Priority

How well you've paid past debts helps lenders approve a loan for working capital. By paying down debt on time, you establish a good credit history.

#CaminoTip Don't use working capital to purchase assets. Make a budget so you can track expenses.

The Most Common Sources Of Short-Term Working Capital

Business Loans

Essentially, when a company borrows money from a bank or other lending institution, you can use those funds to cover daily operational expenses. This can be especially useful in situations where the company is facing a temporary cash shortfall or looking to expand its operations but doesn't have enough funds on hand. So, a business loan can provide the extra cash that a company needs to keep running smoothly, making it a crucial source of working capital. Apply For A Business Loan!

Equity

If your business is in its first year of operation and has not yet become profitable, then you might have to rely on equity funds for short-term working capital needs. You may inject these funds from your own personal resources or from a family member, a friend or a third-party investor.

Trade Creditors

You might be able to solicit trade creditor's help in providing short-term working capital. If you have paid on time in the past, a trade creditor may be willing to extend terms to enable you to meet a big order. For instance, if you receive a big order that you can fulfill, ship out and collect in 60 days, you could obtain 60-day terms from your supplier if 30-day terms are normally given. The trade creditor will want proof of the order and may want to file a lien on it as security, but if it enables you to proceed, that should not be a problem.

Factoring

Once you have filled an order, a factoring company buys your account receivable and then handles the collection. This type of financing is more expensive than conventional bank financing but is often used by new businesses.

Lines Of Credit

A line of credit allows you to borrow funds for short-term needs when they arise. The funds are repaid once you collect the accounts receivable that resulted from the short-term sales peak.

Having Enough Working Capital Is Synonymous With Success

Your goal as a business owner is to have sufficient assets to cover any short-term debt and unexpected expenses. Keeping a steady and reliable cash flow allows you to make financial decisions without worrying about whether there's enough money in the till. If you don't have available cash, consider applying for business financing options. By taking a proactive stance relating to your business finances, you're able to keep your business operational and growing.

If you need a working capital loan, Camino Financial is a great alternative.

Apply here! Apply For A Business Loan!