Every business owner should have a good grasp of working capital, both in concept and practice. In broad strokes, having too little working capital can doom a business to failure but having too much isn’t great either. An overabundance of working capital means you’re missing out on growth and opportunity. To find the right balance, you need to know how to measure the working capital you have, learn how much you need, and find out how much it takes to grow your business. This article will give a few pointers and help you get more familiar with the working capital part of running a business.
What You Have Now
In concept, working capital is simply your current assets minus your current liabilities. But, like many aspects of running a business, it’s not quite that cut and dry. When you’re looking at your current assets, only include what you plan to turn into cash within a year. Your current liabilities should not include a loan principal that comes due years from now. If you’re paying interest on that loan now, those payments do belong in your working capital calculation. Your company’s working capital may also change throughout the year, especially if you operate seasonally. Use past performance as an indicator of your upcoming needs.
The assets minus liabilities formula will return a dollar amount of the net working capital you have now. There’s also what’s called the working capital ratio, or WCR. To get your WCR, divide your current assets by your current liabilities. The ideal WCR varies by industry, but you’ll commonly find 1.5 to 2.0 is the sweet spot. If you want to know what’s considered the target for your particular industry, you can find this information by looking at publically traded companies in your industry. Information is usually easy to get from the company’s website (for investors to see), data reporting groups like Dun & Bradstreet, or the US Securities and Exchange Commission.
Why It’s Important
So now you’ve got two numbers to work with, your net working capital and your working capital ratio. But why are these numbers important, who’s looking at them, and how do you change them? Calculating your working capital tells you if you have enough and how much you need to increase over time if you are targeting growth.
Working capital is also important to investors and lenders. These numbers point to your business’s operating efficiency and short-term financial stability. Lenders look at WCR, net working capital, annual revenue, tax returns, and personal finances to make important decisions. If you’re looking for investors to grow your business, you need to know how much available capital it will take to hit your goals.
How to Grow Your Business With an Eye Toward Working Capital
Growing your business means an increased need for working capital, both to jump-start that growth and to maintain it. The first stage in determining how much working capital you’ll need is to look at your turnover rates. You’ll want to calculate your accounts receivable (AR) turnover days, inventory turnover days, and accounts payable (AP) turnover days. To jump-start growth in your business, you’ll need to increase both your inventory and accounts receivable. That takes working capital.
To know just how much working capital that jump-start will take, build a projected income statement. It needs to include projected accounts receivable, projected inventory, and projected accounts payable. The difference between these numbers and the turnover numbers is how much additional working capital you’ll need to reach your goal. In other words, it’s the change in AR, plus the change in inventory, minus the change in AP.
Where to Get It
Now that you know how much working capital you need, it’s time to figure out where to get it. If you discover your WCR is lower than your industry’s standard, it’s important to figure out why. Look for any cash leaks. Are there any expenses flying under the radar that need to be cut? This can happen easily when you’ve got expenses that auto-renew. Measure staff efficiency. It may be time to make some difficult staffing decisions. Check that you’re getting the best prices and repayment terms from your material and supply vendors.
If you find you need external sources of working capital, you have many working capital financing options. A common choice is a working capital line of credit. Lines of credit work much like a business credit card in that you have a revolving account with a set credit limit. But lines of credit are typically less expensive to keep than credit cards. The general rule with a working capital line of credit is not to exceed 10% of your gross revenue. You’ll also want to avoid eating up your balance with purchases like real estate, equipment, or construction. There are more appropriate tools to handle those expenses, such as CRE loans, SBA loans, and equipment leasing.
Lines of credit aren’t the only option when you’re looking to boost working capital. Factoring lets you sell AR assets without adding debt. You get a percentage of the invoice value right away and the factoring company recoups the funds directly from your customer. There’s no payment you need to make back to the factoring company unless your customer fails to satisfy the invoice.
A sale-leaseback is another loan-free way to get a working capital infusion. Your company sells an asset, like property or equipment, and then pays to lease it back over time. It’s a way to get an immediate cash influx without giving up the use of critical assets. You may have the option to buy back the asset when the lease is up, or even upgrade to a new model. If you anticipate pursuing a buy back option, talk with your broker in order to pursue the right lease agreement.
A third viable option to add to your cash flow is a cash-out refinance. That typically involves real estate that’s increased in value since the initial purchase. It could mean you’ve increased your net operating income or property values have gone up. You can get a new loan based on the new value of the asset. That new loan pays off the original loan, netting you the difference in cash.
Who Can Help
The examples above are just a few ways to generate added working capital. They don’t, of course, take into account your business’s specific goals and situation. To optimize your working capital potential, you need someone who can give one-on-one advice. No blog article or magazine is going to have all the answers you seek. You need a financial broker who has a broad network of lenders and the flexibility to adapt to your financing needs.
A loan broker helps you think outside the box to build your cash supply for growth. It’s their job to find money where nobody thought to look. Getting a fresh look at your financials can help identify opportunities that are hard to see when you’re too close. Work with a reputable broker with experience providing business advice. It will save you time and money that you can use to direct your company’s path forward.