Ensuring that your small business moves forward or starting a business can be a scary proposition. While building your business from the ground up, you may think, “What is working capital, anyway?”
Is this business concept as straightforward as it sounds or is there more to it than meets the eye?
Understanding the ins and outs of working capital is how you reach your business and personal goals. By optimizing its influence on profitability, you can successfully manage your business’s cash flow.
We’re here to help you sort through this concept so your business remains stable and positioned for growth.
What is Working Capital?
In the simplest of terms, working capital is how much liquidity your business has. It can also be considered as how much money your business has that can be invested to continue its growth.
Also referred to as Net Working Capital (NWC), it’s a metric that can help you understand the finances of your business and maximize profits.
If you have bad working capital, your business might be in danger and you need to fix it ASAP.
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.
What is the Working Capital Formula?
In simple terms, you itemize your assets and subtract from that total your current debts.
Working Capital = Current assets / Current debts
“Current debts” can also be referred to as “Current liabilities.”
This formula is very easy to use and will help you understand how much working capital you have.
There’s a way to identify if your assets and liabilities work together in harmony. A comparative number called a working capital ratio helps you make that determination.
Working Capital Ratio Formula
With the Working Capital Ratio, small business owners can understand how their business is doing, after all, it is well known that assets must exceed liabilities in order to realize a profit. If the margin between the two is too close, your business suffers.
Here’s the formula for the Working Capital Ratio:
Working Capital Ratio = Current assets / Current liabilities
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
Working Capital Ratio = 1.6
In this example, your business’ ratio is 1.6. But… is that good or bad?
What is a good working capital ratio?
A good working capital ratio is considered anything between 1.2 and 2.
By keeping tabs on this ratio, you can quickly assess whether you need to tweak your business plan or make other adjustments to cash flow.
Remember, there are numerous options at your disposal to improve your company’s financial health.
How to Improve Your Working Capital: 10 tips
If you’ve kept an eye on your working capital ratio and it’s below the recommended, you can still work things out to keep your business’ finances healthy.
Here are several ways to improve your working capital:
- Try to reduce the time it takes for you to receive payments
- Don’t offer a client payment facilities if he’s known for not paying on time
- Create penalties for late payments
- Keep an eye on past-due accounts
- Make sure there aren’t any unnecessary expenses in your business
- Work with suppliers that offer discounts and offers and negotiate payment terms
- Explore marketing to get more clients and increase your sales
- Don’t stockpile your inventory
- Make sure you use tax incentives when filing your taxes
- Find an external source of capital
Keep reading to find out the best external sources of money that can help your working capital.
What Types of Capital Sources Fund Your Working Capital Needs?
Maybe you’re already thinking, “How do I implement working capital to achieve financial success?” The way you streamline your day-in and day-out operation help provide a cushion of available funds.
Here are five sources of capital that safeguard your cash flow so there’s money left over for growth.
1. Small Business Loans
Small business loans are very versatile forms of financing: they can be used to buy machinery, pay previous debts, or even to improve your working capital.
You can find a small business loan that fits your business very easily, as there are many lenders out there that work every day with small businesses.
A small business loan is the BEST way to improve your working capital.
2. Lines of Credit
Sometimes no matter what you do, businesses endure temporary slumps. To ride out these low cycles, short-term loans shore up your business’s financial health. With a business line of credit, you can advance cash as needed. The lender needs revenue data information to ascertain performance and set a credit limit for working capital. In most cases, you can transfer funds into your account using a checking account or even a secure mobile app.
It’s a common practice for small business owners to make personal contributions to their businesses. The owners can make contributions and be paid back when there’s a net gain in retained earnings. Furthermore, other family members and third-party investors may also agree to contribute money to build up your business’s equity.
4. Business Credit Cards
For convenience, credit cards are designed specifically for small business usage. Your available credit limit will depend on credit scores and current financial statements. Many business credit cards offer business rewards like airline bonuses, no annual fees, and cash back on select business purchases. Interest rates may be at a fixed lower percentage rate for a specified time and variable rates thereafter. However, business credit cards come with a drawback: be aware that rolling over more than 30% of your credit card limit every month will hurt your credit.
5. Trade Creditors
You can delay payments for goods and services by working with trade creditors. You’re able to manage short-term cash flow without using personal funds to actualize growth. The flexible arrangement allows you to work out credit terms tailored to your business needs. This provides some wiggle room in your budget when your accounts payable aren’t due until 60 days out. Even though you can always pay off debt sooner, having additional time for payables is advantageous. For instance, your business may have a slower month or unforeseen operating expenses could crop up.
New businesses sell their accounts receivable to third-party factoring companies. This way you receive cash immediately as the third-party companies purchase your accounts for cash at an agreed rate.
7. Online Term Loans
Online lenders make funding easy so you don’t experience any downtime in your finances. Different from traditional bank loans, online term loans are more convenient as you apply from the comfort of your home or office, the process is much shorter and they come with some extra perks.
How Does Working Capital Work in the Real World?
1. Upfront payments
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), most probably you require an upfront payment from your clients.
2. Payment in 30 days
Manufacturing companies and businesses in the labor-intensive construction industry normally set up a 30-day payment schedule with customers. As work is completed 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.
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.
Working Capital is Synonym with Success
It doesn’t take long to transition from “What is working capital?” to “Sign me up!” It’s a huge relief to know you can control your cash flow to strike a balance between work and family obligations.
At a moment’s notice, you want to have enough assets built up to use as available operating capital. Your goal is to have sufficient assets to cover any short-term debt and unexpected expenses. To achieve that measure of success, you can monitor your working capital ratio and take steps so that your business stays in the black.
By taking a proactive stance relating to your business finances, you’re able to see a return on your investment as quickly as possible.
Whether you have available cash or use a small business loan, consider setting up a rainy day fund to plan for future expansion. This planning fund may cover items like adding on an additional building or renting a larger space. You may want to upgrade your business software, purchase newer furniture, or invest in technology that gives you an edge over competitors.
Monitoring your working capital is an important way to maximize profitability and avoid losing credibility with lenders or customers. As many business owners know, opportunities arise quickly. By keeping a steady and reliable flow of cash, you can make financial decisions without worrying about whether there’s enough money in the till. You’ll no longer need to sidestep the slow dance between having too much or not enough working capital.
Camino Financial Can Help You Fund Your Working Capital Needs
Camino Financial is a family-owned small business. We know what it feels like to go up against other competitors and to manage capital so a business thrives.
Our mission, “Never Leave a Business Behind” is heartfelt and fuels our passion to help other small businesses.
Take for instance Baldemar. He went from working in a coal mine to starting a small business that installs and repairs equipment. But he needed working capital to continue growing and getting profits.
That’s when he met Camino. He learned first-hand what it means to work with a lender that is all-in to help businesses grow.
He was able to increase his credit score by 34 points and have an annual growth of 88%.
Camino Financial’s small business loan amounts range in size from $5,000 to $400,000 with fixed interest rates and monthly payments. Pre-qualification is built into the loans so your credit score is not affected. And the best thing is that we don’t require collateral as part of the loan process.
Our simple and quick application process only takes 4 easy steps.
Ready to take the first step to access capital and grow your business?