What is Working Capital? When should you apply for working capital, and how working capital can work for small business owners. This is not the simplest concept to explain and we know that it takes more than a 30 second video to get it right.
What is working capital financing?
If you've ever heard the phrase "Cash flow is king," it's talking about the working capital requirements of a small business. It's not uncommon for businesses large and small to fund working capital needs by borrowing. But before you borrow, you should make sure you really understand what your working capital needs are to make sure you get the right financing for your business.
First, let's take a look at working capital from the accounting perspective. The definition of working capital is current assets minus current liabilities. It's not enough to simply have cash in the bank at the end of the month.
What are your current assets? They're made up of cash in the bank, your current accounts receivable, and your inventory. Your current liabilities are defined as your current accounts payable, and any long term payables your business may have. You'll want to think small business loans, lines of credit, etc, are in this category as well.
If you divide the value of your current liabilities into your current assets, you'll come up with a ratio of assets to liabilities. The goal should be to shoot for twice as many assets as you have liabilities or 2:1 ratio. Getting to a two to one ratio is challenging for many businesses. But anything below a one to one ratio is a giant red flag that you have negative working capital, even if you have cash in the bank at the end of the month.
So what does this mean for a small business? For small businesses, it might make more sense to consider the formula in terms of the average number of days it takes your inventory to turnover, how quickly you need to pay for that inventory, and the average number of days it takes for your customer to pay you.
If your customers don't pay you quickly enough to meet your financial obligations to your suppliers, or your inventory sits on the shelf too long, you will have trouble meeting your working capital needs out of cash flow.
In other words, staying on top of your average inventory terms is just as important as monitoring your accounts payable and accounts receivable to maintain a ratio of one to one or better with the goal of two to one.
For many small businesses, it can be a struggle to fuel their working capital needs with their accounts payable alone. Many businesses turn to financing to bridge the gap to meet the shortfall. Keep in mind, any financing you use for working capital becomes a liability and needs to be included in your ratio.
So if you're not careful, you could negatively impact that metric by borrowing and making your business unprofitable. Which is why I recommend borrowing working capital only to increase the value of your business or to capture additional ROI.
I know this may sound like a bunch of accounting mumbo jumbo, but this is a very important ratio to understand. And although it's fair to say that most businesses never attained the two to one ratio, that doesn't mean you should be discouraged from trying to get there.
How do you know if working capital financing makes sense for your business? Once you understand your working capital needs, and whether or not you have the internal cash flow to meet all those needs, it could make sense to consider borrowing to cover any short term gap to fuel growth.
For example, retailers might borrow to fund a seasonal inventory build up, or businesses like Landscape Contractors might borrow to bridge from one season to the next. Before you agree to any loan, make sure that you have the cash flow to support the periodic payback.
A loan may not always be the best option for your business, particularly if it throws your ratio into negative territory. If possible, you should plan as far ahead as you can to anticipate your working capital needs.
In addition to your accounts receivable, there are several other sources of capital to finance your working capital needs. Here are three examples.
Trade credit.
If you are on good credit terms and have a good relationship with your vendors and suppliers, it can be possible to negotiate payment terms to accommodate your business needs. Suppliers are often amenable to working with their best customers when they need to fund a large order or to ramp up a new contract or bridge a short term need for additional working capital by extending payment terms. Of course, you'll likely have greater success in negotiating with a supplier if you're currently on good payment terms with them.
A short term small business loan.
A short term business loan think in terms of three to 12 months could be a good option for financing small businesses working capital needs. Depending on your credit profile, the industry you're in and the overall health of your business, you could have more than one option available to your business. A short term loan may be a great option.
A business line of credit
Llines of credit can be more difficult to qualify for than a short term business loan. But if you qualify, they offer the ability to access a revolving business credit line. Use it when you need it, pay interest on the amount of credit you use, pay off the balance, and then use it again. Lines of Credit are available from both traditional lenders like a bank or credit union, as well as online lenders like OnDeck.
To learn more about working capital financing, check out OnDeck's Small Business Resource Center at ondeck.com/resources.
Transcribed by https://otter.ai
Kommentare