Working capital. What is it? Why do you need it? More importantly, how do you get it?
Whether you’re struggling to grow your business, take advantage of bigger projects, or remain afloat during tough economic times, working capital can help.
Working capital supports your daily running costs, funds larger projects and can help you remain afloat during even the most trying times, including the economic downturn.
In this post, we explore everything you need to know about working capital so that you can survive these uncertain times, and take advantage of those big opportunities when they do arise.
What Is Working Capital?
The money you have on hand, whether profit-savings, a bank loan or other means of raising capital, is your working capital. Working capital funds your day-to-day operations, helps you pay rent and staff, and covers other operating expenses.
To understand it, we need to look at how to calculate it.
How to Calculate Working Capital
The calculation is simple: Subtract current liabilities from current assets. Current assets are cash and assets you can convert into cash within a year. These assets comprise accounts receivable, inventory and short term investments.
Current liabilities are short term debts or accounts that you need to settle within a year such as accounts payable, overdrafts, sales tax, payroll expenses and wages.
You should aim to have more current assets than liabilities or positive working capital. If current assets don’t exceed current liabilities, you have a deficit and may have problems paying creditors.
Even if you have a profitable business, you can struggle. Cash may be tied up in assets such as debtors, and an inability to convert them into cash signals weak liquidity.
But even after calculating your working capital, how do you know what amount is suitable? Enter the working capital ratio.
Working Capital Ratio and What it Means
The ratio is a measure of the financial health of your business. The formula is:
current liabilities/current assets
The ratio helps you determine if you have enough operating capital to cover your short term debt. Anything below one indicates negative working capital. Anything above 2 suggests your business isn’t investing excess working assets, and has too much cash tied up in inventory or debtors.
A ratio of between 1.2 and 2 is usually sufficient. A declining ratio over the long term could be a red flag and requires immediate attention. For example, it could indicate that your collections procedures are slow.
When You Need Working Capital
There are two main scenarios where you need working capital:
- To keep your business afloat when there’s less money coming in. For example, due to an economic slowdown or if you run a seasonal business and have marked slower periods.
- To fund growth or big projects. For example, if you’re starting a large project that you only get paid for upon completion, you need capital to keep you going during that period.
And if you don’t have that capital, you’ll have to find it or risk possible project failure. You could get a bank loan, but the application process takes a while—and even then, approval isn’t guaranteed.
The solution is to find funding elsewhere.
How to Get Working Capital
Here are five ways to get more working capital:
1. Speed Up the Collection Process
Working capital shortages often arise due to delays in payments from clients. These delays will lengthen your working capital cycle (WCC). Your WCC is the time it takes to convert current assets and liabilities into cash. A longer cycle means money is tied up in liabilities and assets for longer.
For example, if you pay suppliers in 30 days, but it takes you 90 days to collect receivables, your cycle will be 60 days. Your goal is to reduce that cycle. One way you can do this is by investing in solutions and strategies to speed up the collection process:
- Track collection time with clients so that you know which clients are the slow payers.
- Renegotiate payment terms with existing clients, so they pay you sooner.
- Improve your invoicing procedures by investing in tools that help you get paid faster.
- Make payment easy for clients by accepting their preferred payment method, such as credit cards. FreshBooks, for example, accepts Amex, Mastercard and Visa.
- Encourage early payment by rewarding and penalizing clients. Include a discount for early payment and penalties for late payment in the form of an interest fee. But, make sure you understand when it’s suitable to charge late payment fees.
- Include the correct details on the invoice to avoid back and forth emails that only delay payment. For example, make sure you address it to the right person and include the PO number.
2. Request an Upfront Deposit
There’s nothing more frustrating than a project coming to a halt due to a money shortage. Asking for an upfront deposit gives you working capital to cover costs for the duration of the project.
Deposits also minimize the chances of non-payment. You can request deposits via email and have clients pay it to your bank account.
While deposits will give you extra cash, charging a deposit isn’t always the best option. For example, you may charge a deposit for a client, but waive it over time as you build a relationship and learn to trust them.
3. Peer-to-Peer Lending
Peer-to-peer loans cut financial intermediaries and bring lenders and borrowers together via an online platform. Due to lower operational costs and no middle-man, they’re able to offer favorable rates to borrowers. The platform takes a small percentage, but this is nothing in comparison to what banks might take.
While these loans are easy to get, there’s a higher risk if the lender defaults on a loan. But, you can overcome this by checking their risk profile on these sites.
When someone wants a loan, they have to fill out forms. The platform will do a credit check, assess their risk profile and categorize them accordingly.
4. SBA Loans
SBA loans are loans that the Small Business Administration guarantees. Instead of offering these loans, the SBA reduces the risks for banks through a guarantee.
These loans are ideal for long-term working capital requirements. Although they provide a safety net for big projects, the approval process takes time, and you have to meet strict requirements:
- You have to be in business for two years or more
- You need a credit rating of more than 680 to show you can pay off the loan
Nevertheless, they’re worth pursuing as interest rates are low and usually between 6-8%. I say “usually” because the SBA also offers disaster loans at lower interest rates:
- Loans through the Payment Protection Program designed to help small businesses struggling as a result of COVID-19. These loans have a maximum interest rate of 10% over 10 years. You can apply for this loan through an SBA-approved vendor. To find one, visit the SBA website.
- Economic Injury Disaster Loan (EIDL) program designed to help small businesses who fall within an area declared as a disaster zone. Interest rates are fixed at 3.75%, and the maximum loan term is 30 years. Again, you can apply for assistance on the SBA website.
For more information on all SBA loans and to see if you’re eligible, visit the SBA loan page.
5. Invoice Financing
You shouldn’t confuse invoice financing with traditional factoring. With conventional factoring you enter into long-term agreements, fees are high, and they’re intrusive (the provider contacts your clients).
However, with invoice financing, you sell unpaid invoices to a third party and get the cash immediately. You pay interest against the invoice value with interest rates starting as low as 2.5%.
There are many companies online that offer this service, including Fundbox, a FreshBooks partner.
Working Capital Watch-Outs
There are various lending practices you need to be aware of and sources of funding you should avoid.
Beware of Hidden Fees
Often the advertised cost of the funding is not the actual cost. Many lenders charge hidden fees such as subscription and inactivity fees. So, read the fine print and understand the actual cost to avoid unexpected, and often, high fees.
Avoid Large Lines of Credit You Don’t Need
Make sure you don’t over finance. Many businesses get larger and larger lines of credit, when, in fact, they only need it a little.
Avoid Financing New Customers with Revenue from Old Ones
Many small business owners use the revenue from a past customer to finance the next customer. If you do this often, you can quickly run into cash flow problems.
The point is: Whenever you’re borrowing money, do your own thorough due diligence and avoid making bad decisions out of a sense of desperation.
The Bottom Line on Working Capital
Working capital is crucial for your day-to-day, funding your growth, and helping you out during tough economic times.
That’s why it’s vital to get to grips with it: Understand what it is, learn how to calculate it, and know where to get funding.
How you go about it will depend on your business requirements. You may need to speed up collection procedures, request an upfront deposit, apply for a short or long term loan, or use invoice factoring.
Whatever you decide, rest easy knowing you have working capital to grow during the good times and survive during the tougher times.
To learn more about working capital, download our free Working Capital eBook.
This post was updated in April 2020.