What is working capital – and why is it important?
You may not talk about working capital every day, but this accounting term may hold the key to your company’s success.
Working capital affects many aspects of your business, from paying your employees and vendors to keep the lights on and planning for sustainable long-term growth. In short, working capital is the money available to meet your current, short-term obligations.
To make sure working capital works for you, you’ll need to calculate current levels and project future needs. Consider ways to make sure you always have enough cash.
How to calculate working capital
You can get a sense of where you stand right now by determining your working capital ratio, a measurement of your company’s short-term financial health.
Working capital formula:
Current assets / Current liabilities = Working capital ratio
If you have current assets of $1 million and current liabilities of $500,000, your working capital ratio is 2:1. That is considered a good ratio, but in some industries or kinds of businesses, a ratio as low as 1.2:1 may be adequate.
Your net working capital tells you how much money you have readily available to meet current expenses.
Net working capital formula:
Current assets – Current liabilities = Net working capital
For these calculations, consider only short-term assets (cash in your business account, money clients owe you), and the inventory you expect to convert to cash within a year.
Short-term liabilities include accounts payable — money you owe vendors and other creditors — as well as other debts and accrued expenses for salary, taxes, and additional outlays.
Understanding your needs
Getting a real understanding of your working capital needs may involve plotting month-by-month inflows and outflows for your business. A landscaping company might find that its revenues spike in the spring. Then cash flow is relatively steady through October before dropping almost to zero in late fall.
On the other side of the ledger, the business may have many expenses that continue throughout the year.
Parts of these calculations could require making educated guesses about the future. While historical results can guide you, you’ll also need to factor in new contracts you expect to sign or the possible loss of valuable customers. It can be particularly challenging to make accurate projections if your company is overgrowing.
These projections can help you identify months when you have more money going out than coming in, and when that cash flow gap is most extensive.
Four reasons why your business might require additional working capital
Seasonal differences in cash flow are typical of many businesses. You may need extra capital to gear up for a busy season or to keep the business operating when there’s less money coming in.
Almost all businesses will have times when additional working capital is needed to fund obligations to suppliers, employees, and the government while waiting for payments from customers.
Additional working capital can help improve your business in other ways, for example: enabling you to take advantage of supplier discounts by purchasing in bulk.
Working capital can also be used to pay temporary employees or to cover other project-related expenses.
Finding options to boost your working capital
An unsecured, revolving line of credit can be a useful tool for augmenting your working capital. Lines of credit are designed to finance temporary working capital needs. Terms are more favorable than those for business credit cards, and your business can draw what it needs when it’s needed.
A credit card can be a convenient way to cover incidental expenses, but it’s not the best solution. Some limitations include higher interest rates, and the ease of running up excessive debt.
Qualifying for a working capital line of credit
When you apply for a line of credit, lenders will consider the overall health of your balance sheet, including :
working capital ratio
net working capital
Small business owners’ business and personal finances tend to be closely intertwined. Most lenders will examine your financial statements, credit score, and tax returns. They can ask for a personal guarantee of repayment.
Many factors affect the size of a working capital line of credit. A good rule of thumb is that it shouldn’t exceed 10% of your company’s revenues.
Two working capital missteps to avoid
Don’t confuse short-term working capital needs and longer-term, permanent requirements.
It can be tempting to use a working capital line of credit to purchase machinery, real estate or hire permanent employees. Don’t, these expenditures call for different kinds of financing. If you tie up your working capital line of credit on these expenses, it won’t be available for its intended purpose.
Your LendrzHub specialist can help you better understand your working capital needs and what steps you may need to prepare for any situation. While you can’t predict everything about running a company, a clear view of working capital can help you operate smoothly today. And set you up for long-term growth tomorrow.
Let the specialists at LendrzHub help you obtain the working capital your business needs.