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What is Working Capital?

business owners reviewing finances

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 keeping 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 your working capital works for you, you’ll need to calculate your current levels, project your future needs and 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 would generally be considered a healthy 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 such as the cash in your business account and the accounts receivable — the money your customers owe you — and the inventory you expect to convert to cash within 12 months.

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 other outlays.

Understanding your needs

Getting a true understanding of your working capital needs may involve plotting month-by-month inflows and outflows for your business. A landscaping company, for example, 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 and winter. Yet 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 you can be guided by historical results, you’ll also need to factor in new contracts you expect to sign or the possible loss of important customers. It can be particularly challenging to make accurate projections if your company is growing rapidly.

These projections can help you identify months when you have more money going out than coming in, and when that cash flow gap is widest.

4 reasons why your business might require additional working capital

  • Seasonal differences in cash flow are typical of many businesses, which 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.
  • Extra 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 an effective 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 only what it needs when it’s needed.

While a business credit card can be a convenient way for you and top employees to cover incidental expenses for travel, entertainment and other needs, it’s usually not the best solution for working capital purposes. Limitations include higher interest rates, higher fees for cash advances 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 your working capital ratio, net working capital, annual revenue and other factors. See what banks look for from businesses seeking financing.

Because small business owners’ business and personal finances tend to be closely intertwined, lenders will also examine your personal financial statements, credit score and tax returns. You’ll be asked for a personal guarantee of repayment.

Although many factors may affect the size of your working capital line of credit, a rule of thumb is that it shouldn’t exceed 10% of your company’s revenues.

2 working capital missteps to avoid

  • Don’t confuse short-term working capital needs and longer-term, permanent requirements
  • While it can be tempting to use a working capital line of credit to purchase machinery or real estate or to hire permanent employees, 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 small business banker 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.

   
 
 
 

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