Working Capital and Your Small Business
Working capital is the amount of money available to a company to cover its short-term expenses for the upcoming 12 months. Such expenses might include employee salaries, advertising costs, insurance premiums, supplies, inventory, and taxes. Specifically, working capital refers to a company’s liquidity for the year ahead.
Calculating your business’ current working capital is very straightforward. The formula is simply:
Current assets - Current liabilities = Working capital
Current assets are things your business owns that can be converted into cash within the next 12 months, including checking/savings accounts, inventory, and accounts receivable. Current liabilities, or accounts payable, include payments on short-term debt, rent, utilities, tax payments, interest, and the cost of supplies and materials you need to purchase to produce the goods you sell.
For example, a company’s working capital calculation could look like this:
- Cash: $30,000
- Accounts Receivable: $20,000
- Inventory: $50,000
- Accounts Payable: $60,000
Capital Needs Vary
Some businesses require more working capital than others. A company that keeps a physical inventory, such as a retail or wholesale business, will need more working capital than a business that strictly provides a service, like an accountant or consultant.
Seasonal businesses also require large amounts of working capital during certain times of the year when they’re ramping up for the busy season; think of a department store increasing inventory and staffing for an influx of customers during the holidays.
So Much Depends on Sufficient Working Capital
Working capital is crucial to the success of your business. You need it to meet the ongoing needs of your company. Having cash on-hand enables you to pay your short-term debt and safeguard your operation with a liquidity cushion.
Working capital allows you to:
- Keep your inventory stocked: Without sufficient inventory, you won’t reach your sales potential as you’ll need to wait for your current inventory to sell (to generate cash) before restocking.
- Plan for unpredictable sales activity: Changes in consumer demand or a key vendor’s ability to supply can cause an unexpected downturn in sales. Having sufficient working capital allows you to recover from missed sales and revenue goals, bridging the gap to better circumstances.
- Fund future growth: All businesses, particularly newer ones, need to show positive financial growth, and working capital helps fuel that growth. For example, funding is required to pay sales and marketing personnel, cover advertising costs, and buy items that vendors unexpectedly put on sale that you can turn over quickly at a high-profit margin.
Working capital is meant to be spent — it’s a way to re-invest in your business. Investing in advertising, sales, and marketing wisely creates more working capital, fueling your next stage of growth.
How Much Working Capital Do You Need?
In addition to the type of business you own, there are two other significant determinants of the amount of working capital you need: your operating cycle and your management goals.
Operating cycle. Ideally, a company can pay its short-term debts from its sales revenue. But the length of a business’ operating cycle can make this implausible. If your company takes a long time to manufacture and sell a product, you will need more working capital to meet your short-term financial obligations than a company that bills its customers upfront or immediately after services are rendered.
Management goals. Your goals for your business are also an essential factor in determining the amount of working capital you need. If your business is relatively new or an established business in an expansion mode, a higher level of working capital is required.
For example, if your company goals include expanding into new product lines or venturing into new markets, a high amount of working capital is necessary to cover the costs of research and development, which can be considerable.
What If You Need More Working Capital?
As a small business owner, you learn to expect the unexpected. If your company hasn’t had working capital challenges yet, it probably will at some point. There are a couple of avenues you can pursue if you need more working capital.
Keep in mind that taking out any type of loan or line of credit increases risk, and if you can avoid borrowing, it’s beneficial for your business in the long term. Find other ways to trim your business expenses by taking a closer look at your budget. Look for new opportunities in your market and become involved in your community to network for potential partnerships and clients. Finding creative solutions helps avoid taking on additional financial liability for your business.
If you can’t avoid a loan or line of credit, there are a few types available. When considering a line of credit, find one that you can access when needed. Lenders will pay close attention to the health of your balance sheet, including your working capital ratio, net working capital, your company’s annual revenue, and more.
Business Term Loans can offer greater predictability than lines of credit if they offer a fixed interest rate and monthly payment.
Because your personal and business finances may be closely intertwined as a small business owner, your personal financial statements, tax returns, and credit score will also be factored into a lender’s decision on your application for a line of credit. They may also ask for a personal guarantee of repayment.
Another means of increasing your working capital is through a business loan in which funds are provided to the borrower in a lump sum. In addition to providing documentation to the lender, such as company financial statements and financial projections, you may be required to put up collateral such as business equipment, inventory, or accounts receivable. Putting up personal collateral, such as your home, could also be a condition for receiving a loan.
Business Term Loans can offer greater predictability than lines of credit if they offer a fixed interest rate and monthly payment. The amount of money a business can borrow is usually higher with a loan than with a line of credit.
Business Banks on Texell
If you need additional working capital or funds for any other business need, Texell can help with small business loans. We help you determine your exact needs, guide you throughout the application process, and provide stellar rates and service throughout the loan. To get started, call us today at 254.774.5161, or email BusinessLoans@Texell.org.
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