Business success takes planning, coaching, commitment and access to resources, and one of the most important resources for small businesses is adequate working capital. In this article, we take a look at what working capital is, why it’s so critical, how much you need and how to access it.
What is working capital and how is it different from other capital?
In a nutshell, working capital is your company’s current assets minus its current (short-term) liabilities. Current assets include on-hand cash and things that are easily converted into cash, like inventory and accounts receivable. Current liabilities are primarily loans due within a year and accounts payable.
You can consider working capital as the business owner’s personal equity invested in the business. The relationship between the “owner’s money in the business” and “other people’s money” (whether it’s from a lender or from suppliers) is important. Businesses that are highly leveraged and using mostly other people’s money have a higher risk for failure.
When an existing business grows by selling more goods and acquiring new accounts or clients, it’s common for its accounts receivable to increase at the same rate that revenues increase. In this case, there’s a need for additional working capital to finance the build-up in accounts receivable and/or inventories (current assets) until payments are received on goods or services.
In many instances, the term “working capital” is misused. For example, when a start-up company needs to finance operating expenses like advertising and salaries, they often say they need “working capital.” However, these types of expenses should really be funded with the owner’s personal equity. For existing businesses, revenue generated should cover these kinds of operating expenses, ideally with a profit left over.
It’s important that you understand what “working capital” is (and isn’t!) and how your working capital needs may grow when your business grows. It’s not only important for running your business, but can also be valuable when talking to potential lenders or investors.
How much working capital does your business need?
Working capital only relates to the relationship between current assets and current liabilities. You need to understand what levels of cash, accounts receivable and inventory you will need to have on hand in order to meet customer needs and pay suppliers on a timely basis. First, let’s understand the following:
How quickly do your clients pay you (number of days)?
How quickly do you need to replace your inventory?
How quickly do you need to pay your vendors or suppliers?
These components can be used to determine turnover ratios. These ratios tell you the average number of days it takes you to get paid from your customers, the average time your inventory is sitting on your shelves, and the average number of days you take to pay your creditors. Turnover ratios can be determined with the following formulas:
Accounts receivable turnover days = (accounts receivable ÷sales) x 365
Inventory turnover days = (inventory ÷cost of goods sold) x 365
Accounts payable turnover days = (accounts payable ÷purchases) x 365
The steps in this example illustrate how this works to help determine how much working capital is needed for a business.
So what does this chart tell you?
Based on the assumptions noted above, you’ll need to carry current assets of $56,712 (accounts receivable + inventory) in order to meet revenues of $500,000. Your suppliers will help support carrying those assets and will provide support up to $31,233. The working capital difference of $25,479 needs to be money that you have invested in the business.
These numbers can fluctuate if any of the assumptions change, and you should play with the assumptions to see how they will impact your business. The accounts receivable assumption is the easiest to reconsider. We have assumed that your customers will all pay you on an average of 30 days. If you allow them to pay in 60 days then you will need to carry a higher level of receivables. Where will the money come from to carry the higher receivables? Will it come from lenders, suppliers and/or more of your personal equity in the business?
Now that you know what it is, here’s how to up your working capital game:
Use working capital to fuel success
Ideally, the revenue your business generates covers your expenses and results in adequate working capital. The profits you keep in the business are considered part of your owner’s equity and will help increase your working capital so you can carry higher receivable balances and higher inventory levels as your revenues continue to grow. As a result, working capital will only increase if you put more money in yourself or if you retain the profits in the business that the business generates.
Consider a lender’s role in your working capital financing. How can outside financing support your working capital strategy?
Many times during your business cycle you need to carry a higher level of inventory or wait longer for some large receivables to be collected. This could be because your business is seasonal, or maybe you have a sales opportunity with a big customer on a one-time basis. This may create a short-term need for additional cash to carry you through a period of time.
Lenders provide lines of credit for these purposes and they’ll expect that the funds borrowed will be repaid once your need for cash is resolved. Lenders will look at your working capital levels and determine what dollar amount of support they want to provide. Remember, there needs to be an acceptable level of risk sharing between how much money you have put in or retained in the business, and the amount of money lenders are willing to put into it.
Sometimes a short-term need turns into a long-term need. Perhaps you’re unable to repay a short-term loan because your business is continuing to grow revenues at an accelerated rate as those big orders from your customers are reoccurring faster. That’s good news! But you need to be sure that growth is being funded by shared risk.
Your business needs to be profitable and you need to be retaining profits in the business so that you can continue contributing to the money needed to fund growth. Lenders will also share in that funding and can provide you with a longer term loan for what are now your permanent working capital needs (carrying higher levels of receivables and inventory).
Lenders will analyze your financial statements to see that the growth trends are reasonable and will continue, that you are contributing to fund the balance sheet growth by retaining profits in the business, and that the relationship between your money and “other peoples’ money” has not created an overly leveraged condition.
Working Capital Needs Can Create Other Loan Needs
So far we’ve discussed the needs to support the growth of your receivables and inventory, but over time as these assets grow you’ll likely need to purchase fixed assets to support current asset growth. This could include more shelving to store higher amounts of inventory, more equipment to move the inventory, or additional manufacturing equipment to make or process your growing inventory.
When you need these types of assets, you need a longer loan repayment term. Don’t get caught up in the moment of your growth and buy those assets with cash, because you’ll actually be using your working capital to buy them. You need to preserve your working capital for your current asset growth (receivables and inventory). Be sure you match your need for more fixed-asset purchases with a long-term repayment loan from a lender.
Talk to your banker or contact us to learn more about how to use loans to support your working capital strategy.
Win the working capital game:
Working capital is essential for a successful small business game plan. Determine your business’s needs, review your financials regularly and get your working capital to a healthy level that fuels growth. To find out more and learn about working capital loans and other options, talk to small business advisors like our Business Advisory Services team and those at your local Small Business Administration and SCORE offices.