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A Brief Understanding of Working Capital As It Pertains to Your Business

The Basic Formula

It has been said that the lifeblood of any business is its net working capital (WC). The simplest explanation of this figure is the formula:

WC = Current assets – Current liabilities

In other words, it is the amount of assets available to pay off your short term expenses such as salaries, equipment rental, inventory, and so on. Your assets would be considered your cash, accounts receivable, and inventory. The WC demonstrates the amount of liquid assets that are available to sustain and build you business by measuring your company’s efficiency and short-term financial health. As such, it carries great value to those who might be interested in investing in your business or even purchasing it.

A quick look at a company’s balance sheet records over the period of a few years will be an excellent indicator of the financial health of that company. A positive flow of capital predicts that you have a good basis for expansion, growth, and business building. You can pay all you short term debts, operating expenses, and salaries with extra to re-invest in your business. On the other hand, a negative working capital, in which you have more immediate liabilities than cash assets, especially as a yearly trend, can be a huge red flag to investors. This figure indicates that you may not be able to pay your creditors and could end up in bankruptcy court sooner rather than later. It might also suggest that your sales volume is gradually decreasing for some reason, resulting in your accounts receivable shrinking as well, or perhaps, because of poor management your excessive inventory is tying up too much money. A large amount of outstanding customer debt because of slow collections can also damage your figures. When investors want to look at these WC numbers, they are trying to foresee financial difficulties that may lie just over the horizon.

Understanding Deficits

When a situation occurs in which you have assets that are less than your liabilities, you have what is referred to as a “working capital deficiency” or “working capital deficit.” It is possible to have healthy assets and profitability but still have a serious cash flow problem, especially if those assets cannot easily be turned into usable cash. This operating liquidity is essential to being able to pay your short term debts such as bank loans and lines of credit as well as day-to-day operational expenses if your company is going to stay in business. Large companies with huge assets in property, equipment, and inventory have still collapsed because they could not generate enough usable capital to sustain their business and pay short term debt in a timely fashion.

Having a situation in which you are dealing with poor capital position is similar to walking on the edge of a slippery slope. Any unexpected expense can ramp up the financial pressures by forcing you to increase your borrowing just to sustain your business. You will probably be making late payments for which you will be charged, and in the process you will have damaged your credit rating, which means that those you borrow from will charge you even higher rates. Unless you can do something to increase your cash on hand, the situation can become very grim very quickly.

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Working Capital Needs Calculator

Your working capital is used to pay short-term obligations such as your accounts payable and buying inventory. If your working capital dips too low, you risk running out of cash. Even very profitable businesses can run into trouble if they lose the ability to meet their short-term obligations. The calculator assists you in determining working capital needs for the next year.

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Start Up Small Business Working Capital

For new businesses or those about to launch, working capital has a slightly different meaning. It refers to the amount of money you will be borrowing from the bank or a similar lender to keep your fledgling operation going until such time as your revenue is able to cover those expenses. Your start-up money will secure a facility, pay utilities, purchase inventory and equipment, and pay salaries during those first months when very little is coming in as revenue. Calculating the amount that you need to borrow during this interim period is a little tricky for several reasons, and many companies fail because they borrow too much or too little at this launching point. In today’s economy, it is still possible to borrow for a new business, but you will really have to do your homework to be taken seriously without being taken advantage of.

Often, when investors are evaluating a company they look at the working capital ratio as another indicator of the potential for financial success of that business. This percentage is arrived at by simply dividing the current assets by the current liabilities. If the answer is less than 1.0, this indicates the company has a negative working capital with too few liquid assets to cover the short term expenses. On the other hand, if the ratio is above a 2.0 this could indicate poor management of the capital. The company may have too much inventory sitting on its shelves or too much revenue sitting in the bank and not being invested into the further growth of the business. An ideal range for the ratio would be 1.2 – 2.0. These figures indicate that a company has enough cash to cover day-to-day expenses with more to be building internally, which could be upgrading technology or expanding operations, both activities of a progressive and healthy company.

Quick Ratio / Acid Test

An even more telling examination is the “Acid Test” or “Quick Ratio.” By adding up only the cash, accounts receivable, and short term investments, the inventory is totally omitted from the calculations. This new total is then divided by the current liabilities. If the resulting figure falls much below the WC ratio, it becomes obvious that this company is relying heavily on the value of its inventory. This is rather typical of retail stores, and most of the time they get away with it. However, companies that move inventory very slowly because of the nature and expense of the product cannot afford to put all their eggs into their inventory basket without seriously endangering their working capital. Businesses that show good quick ratio scores when examined this way are said to have “passed the acid test for financial integrity.”

Turnover Ratio

One other important tool for examining the financial strength of a company is the “working capital turnover ratio.” This number is discovered by dividing the net annual sales by the average amount of working capital during that time period. Investors may be a bit more cautious today, and every index that helps them see the financial potential in a business is carefully considered. Wise investors also compare these figures to those of similar businesses because they recognize that unique factors may also be at work, depending upon the nature of the business and the product or service offered.

There are a few instances in which having a poor or negative working capital is not necessarily a precursor to financial problems. For example, grocery stores have a very high turnover business. They make revenue every time they open their doors. Because they are able to generate cash so quickly and consistently, they do not need to worry as much about their cash flow availability. Should the unexpected happen, they can simply save up some of this regular cash to ride out the storm.

Cash Flow Management Strategy

Since by now it is obvious that having a healthy working capital is important from both the business owner’s and any potential investor’s perspective, understanding and implementing cash flow management strategies becomes a vital piece in building a sustainable business. Managing your capital in a responsible manner means making financial decisions related to short term financing as well as maintaining a balanced relationship between your short term assets and your short term liabilities. Your ultimate goal will be to be able to continue the company’s day-to-day operations with enough cash flow to cover short term debts in a timely manner and to also handle operational expenses. Most of the decisions that you will be making will be contained within the next twelve months and also will be reversible, should that be necessary.

Measuring Liquidity & Return on Assets

There are a couple of really useful tools that can assist you manage your cash flow.

Improving Free Cash Flow

So, how do you go about managing your working capital so that you have a constant healthy cash flow? There are policies and techniques that you can employ to accomplish this successfully. Learning how to manage those all-important current assets such as cash, cash equivalents, your inventory, your debt, and your short term financing is the meat and potatoes part of the process, and probably the obvious place to start is with cash management. Is money being squandered in the day-to-day expenses of running your company? If you find inefficiency, you will usually also find wasted cash assets.

Cut Unnecissary Capital Expenditures

Maybe it’s time to think through your monthly expenses. Is everything that you are paying for still relevant and necessary? For example, service contracts can be useful, but they also have a shelf life. Maybe that piece of equipment has been sold or retired from your production line. Why are you still paying for service coverage on it? The same idea applies to your insurance policies. Are they still relevant and meeting your needs? All insurance policies should be reviewed yearly and compared to other offers by the competition. While you would not want to under-insure your company to save money, don’t let your agent sell you more than you need or take your business for granted. If he’s not always looking for the best deal for you, you may be losing money.

While you are thinking about insurance, you might review your company’s health plans to see if there is room to shave off some expense there. Maybe you can raise your deductible. It’s definitely worth consideration.

This is a tough one, but do you still require as many employees? No one wants to lose a job or overtime, but reality economics today means cutting where you can cut to keep your business alive and well and to preserve the jobs of as many of the rest of your workers as you can. On a slightly different angle, are all of your employees maximizing their time as efficiently as is possible? If you have someone who seems to work circles around the others, rather than think about whom you can let go, consider how you can use your star employees to inspire and train the others. Rewards and incentives can still go a long way towards improving efficiency and quality of work, not to mention job satisfaction and longevity. Getting all your employees on the team is not as difficult as you might think. Rewarding the fewest sick days or the largest amount of machinery uptime are just two examples or opportunities to make saving money a company project.

As you focus on you and your company’s activities, ask yourself which ones actually are directly related to making you money and producing desired cash flow. Maybe you really don’t need so many meetings or business expense trips when a conference call schedule would work as well. Are there other ways that you can minimize business expense without devaluing your employees, which could produce the very opposite and negative results?

As you improve your capital position your change in needs can lower the cost of capital due to a lower perceived risk in lending your business money.

Supply Chain Management

Inventory supervision is another important aspect of cash flow management. Since your goal is to have uninterrupted production with as little investment in raw materials sitting around, you will have to stay on top of this whole process. Unused inventory represents tying up funds as well as paying for the space in which to store it. However, down time on the production line because of a shortage of materials that need to be re-ordered is a money drainer as well, and unnecessary extra shipping costs are involved with too frequent ordering. The “Just in Time” concept calls for a lean manufacturing system that works through very careful visual or mechanical inventory control. If you can find the point at which your level of inventory is less than the total cost of holding and ordering it, you’re on the right track. When this is done correctly, you can save significantly and increase your capital position.

Many suppliers may we willing to give price consessions if they fear they are about to lose your business. Explain the situation you are in and ask if you can get lower prices for buying in bulk, or ask if they will accept post payment...and see how long you can stretch it out, some firms may be willing to give 60 to 90 days same as cash. If you can push some current liabilities into the future you may not need to borrow as much.

Another piece of this is the idea of understanding and managing the entire supply chain, all those businesses involved in product development and sales from start to finish. Streamlining here can be a huge money saver too.

Collecting Outstanding Payments Quicker

The other side of capital management involves collecting debt in as short a time as possible. One way you can handle debt management is by attracting customers who can increase your revenue while offsetting your cash flow. Offering discounts and allowances can serve more than one purpose. In addition to making purchases more inviting and increasing your short term sales, you can move out-of-stock inventory and reward valuable customers.

Be careful about large volume customers or the reverse of speedy debt collecting could happen. Know their credit history and build in as many pre-pay factors as you can without driving them away. Some companies keep credit cards on file and collect throughout the service process instead of just at the end. The bottom line is to do less work, but for people who actually pay, and don’t do more work for the people who don’t pay.

Sometimes working capital management may involve taking active steps to improve your cash flow, and simply earning more profit through increased sales may not be enough. One way that a company can handle this situation is through issuing common or preferred stock in the business for cash. This could even mean taking on a partner, a possibility but not always the ideal solution. Replacing some of your short term debt with long term debt is another option. In a real bind, it might be feasible to sell some of your equipment and then lease it back from the new owners. When your lease is completed, you will own your equipment once more. Settling short term debts for less than the original stated amount is another opportunity to raise your cash flow, as is factoring, in which case you will actually sell your accounts receivable at a slightly reduced amount to a business or “factor” for ready cash. It will then be the factor’s responsibility to collect your debts for his profit.

Obtaining a Loan

Businesses generally find themselves in a position of needing to borrow money for one of three reasons:

While many different loan options exist, you will want to prepare yourself before you go door-knocking. You will definitely need to know and possibly repair your credit history if it is not impressive. If you can’t fix it soon enough, you had better be able to explain credibly why it is less than favorable. You are also going to need to develop a really sound and thorough business plan that includes everything from start-up details to financial projections with lots and lots of details. Educate yourself not only about your business, but also about your competition and the types of loans that are available to someone in your situation. Finally, be prepared to provide all kinds of documentation including balance sheets for the last three years, income statements of profits and loss, cash flow projections, and your accounts payable/receivable. In addition to business financial documentation, you will also need to make available your personal financial statements and a good description of the collateral that you wish to offer. Everything about you and your business will come under scrutiny by institutions from which you are seeking a loan.

Once your homework is done, it is time to consider the best sources for seeking funding. You might start with family and friends, but you will need to be absolutely honest with them and share the risks that could be involved. You also need to write a contract or promissory note to show your integrity. Both money and important relationships can be damaged irreparably by dishonest financial dealings. A home equity loan will be worth 80% - 100% of your home value and is a cheap loan to acquire. However, there is the risk that you could lose your home if you default, and you need to bear that in mind.

Trade creditors will extend loans so that you can purchase larger amounts from their place of business. It is also possible to sell future credit card receipts up to about $100,000. Getting approved for a bank line of credit allows you to borrow up to a certain amount for short term needs, and then there are the short term loans that will allow you to purchase inventory for a season or a period of usually less than one year. If your business appears viable, you might qualify for a Micro Loan of $5,000 - $35,000.

A relatively new way to acquire extra capital is through the person-to-person online networks. They tend to charge about 7% and will loan up to about $25,000. The process is quick and this is becoming an increasingly popular choice recently. Other sources for money include venture loans, loans from specialized lenders, SBA loan guarantee programs, finance companies (only if you are really desperate), banks, and government loans.

When it comes to considering how much money to ask for, you will really need to spend time thinking through your actual cash flow needs and operating expenses, including salaries, equipment, and office space. How long will it be before you are bringing in enough revenue to support yourself? This is not the time to be overly optimistic. Plan for the worst, so that you will be pleasantly surprised if success and stability come more quickly. Then look for every possible way to cut and trim your budget. As you keep in mind that you will be legally obligated with individual responsibility for you loans, going for the least amount you can get by with is prudent. On the other hand, cutting yourself too short could be potentially harmful to your business.

Because your capital stock truly is the life blood of your company, guard it well, keep it healthy, and infuse it with outside loans only when absolutely necessary. With the shaky economy today is not impossible to survive, but it will take sound, safe judgment and planning to ride this wave to more prosperous times again. The good news is that it can be done.

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