What is working capital?
The money you have on hand, whether profit-savings, a bank loan or other means of raising capital, is your working capital. Working capital funds your day-to-day operations, helps you pay rent and staff, and covers other operating expenses. Whether you’re struggling to grow your business, take advantage of bigger projects, or remain afloat during tough economic times, working capital can help.
Working capital is a key measure of a business’s liquidity and operational efficiency.
Working capital is the dollar amount left over after current liabilities are subtracted from current assets. It’s used to determine if a business has enough assets to pay debts due in one year.
The working capital formula is used to calculate the money available to pay these short-term debts.
Working Capital equals Current Assets minus Current Liabilities If there are excess current assets, the additional resources can be spent on day-to-day operations. This is a great sign for the business and might indicate some flexibility in the use of your resources.
The working capital formula tells us the short-term liquid assets remaining after short-term liabilities have been paid off. It is a measure of a company’s short-term liquidity and is important for performing financial analysis.
Understanding your companies needs is important
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.
Reasons your company might require working cpaital
- 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.
- The biggest advantage of working capital loans is that they are unsecured. For most loans, pledging collateral is essential as it acts as an assurance of repayment. However, this isn’t ideal as it puts your business assets and personal valuables at risk. Working capital loans save you from this hassle.
- you can easily apply for a working capital loan online and will have to submit only a few documents. As a result, the process is easier for you and funds are disbursed faster.
- If you have venture capital backing your business, you have to share your ownership privileges with someone else. You cannot take all decisions and there is a constant risk of losing the funders and investors if anything goes wrong. But with working capital loans, you remain the sole owner of your business. The decisions you make and the strategies you draw up are entirely in your control.
when you have a small business, and it has been running smoothly and experiencing growth, getting a hold of your company’s working capital is an essential aspect of its overall financial health. And while the amount of working capital and the working capital ratio will surely differ from company to company, it is a helpful tool in identifying your business’ profitability. It can even be used to create smart, informed decisions for your business at any stage.
How much working capital does your company need?
After assessing the current status of your business , it’s essential to identify what information signifies in the context of your daily business operations and future goals.
First, identify what’s causing the situation. It may come as a result of various root causes, from poor marketing to high expenditures. Therefore, devise a plan to spend less, improve marketing, boost sales, or generate an influx of capital into your business.
Even if you assess that there’s just enough working capital available, it’s imperative to ponder on the following questions to validate if it’s enough:
- Do you anticipate any surge in expenses that could catapult liabilities?
- Are you geared to investments or expansions that entail capital?
- Are you planning for any operational shifts such as a future inventory purchase, that will require a significant amount of capital?
How is a working capital loan different than other types of loans
The difference between working capital loans and other loans is that working capital loans are backed by your current assets. Loans for capital acquisitions such as equipment are generally backed by non-current assets. General obligation loans that provide growth capital in general rather than being tied to a specific purpose are generally backed by a combination of non-current assets and current and expected profits.
What this means is that a bank will focus on different things when approving each type of loan.
- Working capital loan: Current assets and recent bank deposits that show an ability to repay the loan in full within the coming weeks.
- Acquisition loan: Value of the assets to be acquired in relation to the loan amount plus cash flows high enough to support ongoing monthly payments.
- General obligation loan: Profitability, expected future profitability, assets in relation to debt, and cash flow.
The difference between Unsecured vs Secured working capital loans
A working capital loan can either be secured or unsecured. A secured loan is a loan backed by a specific asset that the lender can take if you don’t repay the loan. An unsecured loan only gives the lender a general right to collect the amount owed.
Secured working capital loans are backed by your accounts receivable. The lender may obtain rights to specific invoices or to your accounts receivable in general. In many cases, the lender will ask you to link your payment processor or deposit account so that the lender can automatically withdraw loan payments.
Unsecured working capital loans often carry higher interest rates because not having anything securing the loan means additional risk for the lender.
How do you get a working capital loan?
There are several options to obtain a working capital loan. Some small businesses simply choose to carry their expenses on a small business credit card or line of credit as a substitute for an actual working capital loan.
For businesses with larger spending needs, asset-based working capital lending comes in several forms. This includes loans backed by your assets, loans backed specifically by your receivables, and factoring (selling your receivables at a discount in exchange for immediate cash).