What is Working Capital?
The money you have at your disposal, be it profit-savings, bank loans or other means of raising capital, is your working capital. Working capital funds your day-to-day operations, allows you to pay rent and staff, and supports other operating expenses. Whether you’re struggling to run your business, looking to expand, or stay afloat in tough economic times, working capital can help.
Working capital is a key metric of the liquidity and operating efficiency of a business. Working capital is the dollar value left over after current liabilities have been subtracted from current assets. It is used to determine whether a business has enough assets to pay debts due in one year.
The formula for working capital is used to calculate the funds available to pay these short-term debts. Working capital equals current assets minus current liabilities If there are excess current assets, additional funds may be spent on day-to-day activities. This is a positive indicator for the business and may indicate some flexibility in the use of your funds.
Understanding your companies needs is important
It is a measure of the short-term liquidity of a company and is important for carrying out a financial analysis. Gaining a proper understanding of your working capital needs may involve plotting monthly inflows and outflows for your business. For example, a restaurant might find that its revenue spikes in the spring, followed by a relatively steady cash flow through October, before falling almost to zero in late autumn and winter. On the other hand, however, the business may have many expenses that continue through the year.
Portions of these calculations may require the making of well-educated assumptions about the future. While you can be guided by historical results, you will also need to factor in the new contracts that you expect to sign or the potential loss of significant customers. It can be particularly difficult to make accurate forecasts if your company is growing quickly.
These forecasts can help you determine months when you have more money going out than coming in, and when the cash flow difference is largest.
Reasons your company might require working cpaital
- Periodic differences in cash flow are typical of many businesses that may need extra capital to get ready for a peak seasons or to keep the business going if less money comes in.
- Just about all businesses will have occasions when additional working capital is required to fund obligations to distributors, employees and the government while awaiting payments.
- Additional working capital can help to improve your business in other ways, such as enabling you to reap the benefits of supplier discounts by buying bulk.
- Working capital may also be used to employ temporary staff or to handle other project-related expenditures.
- The main benefit of working capital loans is that they are unsecured. For many loans, the requirement of collateral is essential as it operates as a guarantee of repayment. This is not ideal, however, as it puts your business assets and personal valuables at risk. Working capital loans will save you from this trouble.
- You can easily apply for a working capital loan online and only a few documents will have to be submitted. The process is easier for you and the funds are distributed more quickly.
- When you have venture capital to back up your business, you have to share your ownership privileges with someone else. You cannot take all decision making, and there is a continuous risk of losing financial backers and investors if something goes wrong. But you remain the sole owner of your business with working capital loans. The actions you take and the strategies you make are entirely in your power.
Because you have a small business, and it has to work smoothly and is growing, getting hold of your company’s working capital is a key aspect of its overall financial health. And although the amount of working capital and the ratio of working capital will surely differ from company to company, it is a useful tool for identifying the profitability of your business. It can even be used to make smart, knowledgeable decisions for your business at any phase.
How much working capital does your company need?
Upon evaluating the current status of your company, it is vital to assess what information is expected by your day-to-day business activities and business objectives.
Identify, first, what causes the situation. It may come from a variety of root causes, from bad sales to high expenditure. Develop a plan to spend less, improve marketing, increase profits, or generate capital inflows into your business.
Even if you consider that there is just enough working capital available, it is absolutely essential to consider the following questions in order to validate them if it is sufficient:
- Are you anticipating any increase in expenditure that might propel liabilities?
- Are you focused towards investments or developments that involve funds?
- Are you looking at making any operational shifts, such as a prospective purchase of inventory, that will take a substantial amount of capital?
How is a working capital loan different than other types of loans?
The thing that is different between working capital loans and other loans is that working capital loans are supported by your existing assets. Loans for acquisitions of capital, such as machinery, are generally backed by non-current assets. General obligation loans providing growth capital in general rather than being linked to a specific purpose are generally backed by a mixture of non-current assets and current and expected earnings.
What that really means is that the bank will concentrate on various things when it approves each type of loan.
- Working capital loan: current assets and recent bank deposits that demonstrate the ability to effectively repay the loan in the coming weeks.
- Acquisition loan: the value of the assets to be acquired in relation to the amount of the loan plus cash flows high enough to support continual monthly payments.
- General obligation loan: profitability, future expected profitability, debt-related assets and cash flow.
The difference between Unsecured vs Secured working capital loans
A working capital loan may either be secured or unsecured. A secured loan is a loan backed by a specific asset that the lender can take if you do not repay the loan. The unsecured loan only gives the lender a general right to collect the amount due.
Secured working capital loans are backed up by your accounts receivable. The lender may be entitled to specific invoices or to your accounts receivable in general. In many instances, the lender will ask you to connect your payment processor or deposit account so that the lender can withdraw credit payments automatically.
Unsecured working capital loans often have higher interest rates, because having nothing to secure the loan means increased risk to the lender.
How do you get a working capital loan?
There are a number of options for obtaining a working capital loan. Some small enterprises simply choose to pay their expenses on a small business credit card or line of credit as a substitute for a real working capital loan.
For businesses with higher spending needs, asset-based working capital lending comes in a number of ways. These include loans backed by your assets, loans backed specifically by your receivables, and factoring (selling your receivables at a discount in exchange for immediate cash).
