We have all heard the term “working capital”, but what is it exactly? How do you calculate it? How can you best utilize your working capital for your small business? You’ll find all your answers here.
Working Capital = Current Assets – Current Liabilities
Typical current assets are: cash, accounts receivable, inventory, and short-term investments.
Some business owners also include the current portion of a 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.
Meet Manuela. Manuela is the owner of a beauty salon. These are her current assets and liabilities:
- Cash: $5,000
- Accounts Receivable: $2,000
- Inventory: $8,000
- 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.
What is working capital used for?
Working capital can be used for the day-to-day operations of running a business. Seems pretty straight-forward, yes? It is, so, why do so many small business owners shy away from leveraging it in the best interest of their company? The simple answer is fear. You have worked hard to build your business; you have endured through months, perhaps even years of barely turning a profit, wondering from one pay period to the next, if you were going to make payroll. But, your hard work and perseverance have paid off; you have money in the bank! You have that necessary cushion for times of the year in which you may see a downturn in sales or funds to offer your employees holiday bonuses. Why would you want to spend that? The short answer: to remain competitive.
Now that you know how to calculate your own working capital, we encourage you to use it in a way that can make a difference in your business. Just read below to get some ideas.
6 Ways to Optimize your Working Capital
1. Treat Your Treats
Perhaps your small business is a bakery. When customers come into your shop, they are wanting to treat themselves, which is actually an immersive experience. It goes beyond the cupcakes they are buying; they want a treat for their eyes as well as for the mouth. As such, perhaps it is time to invest in new cases to show-off your latest goodies or brightly colored mixers to give your customers the sense of fun and whimsy that you are trying to cultivate with your array of delightful treats. If equipment is being to show signs of wear and tear, if it’s beginning to look rundown, the first thought of a customer is not going to be, “Wow! They must be doing really well if their mixers are looking so worn out.” No, the first thought will probably be more along the lines of, “Ewww…why can they not buy new equipment? I don’t want to eat anything that was made using that machine.” Certainly, it can be tempting to stick with the tried and true and not invest your working capital in new baking equipment because you want to save money. However, by doing that, it could end up costing you money in the long run.
2. Slap a Coat of Paint On It
No one wants to patronize a business that looks like the house from Grey Gardens. Keeping the look of your space fresh and up-to-date is just as important to please the senses of your customers. Sometimes, that can be as simple as replacing worn-out decorations or making new signs. Other times, yes, it means a complete overhaul to pull down peeling wallpaper or repainting the entire shop. While you may initially balk at the time and money that it will take to do so, think of how much more inviting your bakery will be with a fresh, new look. If your only real decorating skills are the ones to be used on top of cakes, don’t shy away from using some of your working capital to hire a professional to come in and help you develop new color schemes. If you are still concerned about the costs, perhaps you and the designer could also do a bit of bartering for services: the designer gives you a discount and you provide the desserts for their annual holiday party.
3. If You Got It, Flaunt It
You have worked hard to build your business and you are proud of how much people enjoy your cupcakes and homemade ice cream. Growing up, we are always told that no one likes a braggart, but when it comes to being a successful small business owner, it is perfectly acceptable to have the confidence to flaunt your products, services, and products. In this age of social media, many small business owners may shy away from investing their working capital into other marketing efforts, and while Facebook and Instagram may be great ways to spread the initial word, an effective marketing endeavor will need to include flyers, brochures, in-store materials, and coupons. This may be another area in which hiring a professional will produce the greatest results. After all, it doesn’t matter how fabulous your homemade baked goods are if no one knows of them and you aren’t investing in the continuing efforts to spread the word.
4. Happy Employees, Happy Customers
Have the previously mentioned ways to use working capital paid off? Is your business now experiencing growing pains? Are your current employees now being over-worked to keep up with the incoming orders for custom-made cakes? Any good business owner knows that we are only as good as the people with whom we surround ourselves and certainly you want to keep your current employees at their best and not burning out or becoming disgruntled. Perhaps it is time to use some of that working capital to invest in people and grow your team. Not only will it prevent employees from being overworked (which can create resentments that result in resignations, as well as mistakes being made); but also keeping your employees happy and motivated will ensure that you are able to stay on top of the growing demands of the business, thus keeping your customers happy, as well.
5. Grow to Grow
You may have the best baked goods in three counties, but if your shop is cramped, making your patrons feel claustrophobic, stressed or over-heated, no one will want to stop in to enjoy them. Using your working capital to move into a larger space or increase your current space will ensure that you are able to comfortably serve a larger number of customers, resulting in a larger number of customers being served. Remember the movie, Field of Dreams? “If you build it, they will come.”
6. Money Makes the World Go ‘Round
The above suggestions assume that yours is a small business that is not brand new, and therefore you have begun generating income to have some working capital reserved. However, what if you are still quite new in your small business endeavor, but have the need to make some of the improvements previously mentioned? What can you do? Here are the five most common sources of short-term working capital:
- 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. These funds might be injected 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 their 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.
- Line 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. Lines of credit typically are made for one year at a time and are expected to be paid off for 30 to 60 consecutive days sometime during the year to ensure that the funds are used for short-term needs only.
Confused? Learn here the difference between Factoring and Line of Credit
- Short-term Loan: While your new business may not qualify for a line of credit from a bank, you might have succeeded in obtaining a one-time short-term loan (less than a year) to finance your temporary working capital needs. If you have established a good banking relationship with a banker, he or she might be willing to provide a short-term note for one order or for a seasonal inventory and/or accounts receivable buildup.
As you see, there are many ways in which your working capital can work for you. And don’t forget you can always speak to one of our loan specialists at Camino Financial to see if you qualify for a business loan. There is no reason to stress if your business is not yet in a place to have those funds in place. Continuing to invest in your company, while it may seem costly at the time, will garner larger payoffs as you continue to grow.