Everything You Need to Know About Working Capital
September 7, 2017
Working capital. What is it? Why do you need it? More importantly, how do you get it?
Ever been in a position where you don’t have money to pay creditors or employees? Started a large project, only to find that you don’t have to money to fund it?
These situations highlight the need for working capital. It supports your day-to-day running costs and once off projects that can make or break your businesses.
Without it, the survival of your business is under threat, and bankruptcy a possibility.
But don’t worry, in this post we’ll highlight everything you need to know about working capital:
- What it is
- How to calculate it
- Scenarios where you need it
- How to get it
What is Working Capital?
Working capital is the money used to fund your day-to-day operations. It’s used to pay short-term debts and cover other operational expenses. To understand it we need to look at how to calculate it.
How to Calculate It
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. These include 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. You may have problems paying creditors, with the worst case scenario being bankruptcy.
Even if you have a profitable business, you can struggle. Cash may be tied up in assets such as inventory, 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? Do you have enough? Do you have too much?
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.
It 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 isn’t good as it suggests that the company isn’t investing excess working assets, and has too much cash tied up in inventory and 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. By improving those, you’ll improve the ratio.
The ratio also guides investment decisions. It shows prospective investors how well you manage assets and, consequently, how well you run your business.
Regardless, working capital is essential for any business.
When You Need Working Capital
Whether you’re a new, growing, or established business, working capital, is crucial. It’s critical for day-to-day operations, payroll and paying creditors.
It’s even more important when your company’s about to take a big step. For example, if you’re a business 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 it, you’ll have to find it, or risk project failure. You can get a bank loan, but the interest that accrues is often exorbitant and will affect your profitability. The solution is to find funding elsewhere.
How to Get Funding
Here are six ways to get the funding you need to meet your capital requirements.
1. Speed Up The Collection Process
By getting paid faster and not having to wait weeks, and in some cases – months – to get paid, you’ll reduce your working capital cycle (WCC). WCC is the amount of time it takes to convert current assets and liabilities into cash.
A longer cycle means your cash is tied up in liabilities and assets longer, without earning any return. For example, if you pay suppliers in 30 days, but it takes 90 days to collect receivables, your WCC is 30 days.
Here are some strategies to reduce that cycle and ensure your invoices get paid on time:
- Show courtesy in invoices
- Specify exact payment days to avoid confusion
- Make it easy for clients to pay by accepting credit cards
- Use a card reader to accept payment on the spot
- Reward and penalize clients to encourage payment
- Include details on the invoice that the client needs to process it such as, billing address and PO number
- Use business accounting software such as FreshBooks to automate invoicing. The software even lets you specify an upfront deposit
2. Specify an Upfront Deposit
Beyond providing you with upfront capital, a deposit minimizes the chances of non-payment and ensures the client is invested in the process, from the start.
3. SBA Loans
Is there a large project on the horizon? One that will takes months, if not years to complete? Small Business Administration (SBA) loans are the perfect fit.
While they provide financing for an extended period, they do not offer the loan. Rather, the SBA reduce the risk for banks, by guaranteeing the loans that banks issue.
They’re ideal for long term working capital requirements, but it’s harder to get one (compared to other loans):
- 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
But they’re worth pursuing. With interest rates of 6-8%, they’re amongst the cheapest sources of capital. Visit the SBA loan website to see if you’re eligible
Do take note that these loans aren’t suitable for a one-time cash injection, e.g., buying supplies once off for a large project.
4. Short Term Online Loans
Short term loans are ideal for short term capital needs, and it’s easier to get approved. They’re perfect for companies that have been operating for at least one year, have a credit rating of more than 500, and annual revenues of more than $50,000.
Despite the easier approval process, these loans come at a cost with interest rates of between 20-80%.
5. Invoice Factoring
Not to be confused with traditional factoring – which isn’t small business friendly, involves long term contracts, high fees, and is intrusive (providers contact clients) – invoice factoring lets you sell unpaid invoices to a third party, so you have the cash immediately.
You then pay interest on the value of those invoices. Interest rates start as low as 2.5%.
They’re ideal for when unforeseen costs arise, you need a quick cash injection, and you have a long WCC cycle.
Online invoice factors like Fundbox allow you to be selective in the invoices you choose, giving you an advance on that invoice within 24-48 hours. A few perks include:
- A quick screening process which involves checking your credit rating
- Not contacting your clients
- Fair and transparent pricing
FundBox is a FreshBooks partner. For more details on how to get started, visit our Fundbox addons page.
Startups can’t rely on the previous options because startups aren’t established and don’t have a financial record.
Enter crowdfunding; the practice of funding large projects by raising money from a large number of people. It’s a phenomenon that’s taken off in recent years and is ideal for entrepreneurs and startups who need cash to expand.
There are no interest rates, but you need to meet the specified funding amount; otherwise, you don’t get the money.
The Bottom Line
Working capital is crucial for your day-to-day. Without it, you cannot pay expenses, salaries, and other short term debts. Without it you run the risk of having to shut up shop and… you don’t want that!
That’s why it’s crucial to get to grips with it. You need to understand what it is, how to calculate it, and how much you need to stay afloat.
After your calculations, you must then get the funding you need. 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, use invoice factoring or, if you’re a startup, crowdfunding.
Whatever you decide, having working capital will allow you and your business to thrive.
Is there anything you’d like to add? How do you get funding to keep your operation going?