If we had to choose the most vital ingredient for small business success, proper working capital management would top the list. Effectively managing working capital can make the difference between a business that grows smoothly and one that sputters down the road.
While you don’t need to know your working capital figure down to the dollar, you should have a rough sense as to how much money you have available to fund your business as it grows. In this article, we dig into all things working capital—what it is, how to calculate it, and how to use well-structured loans to access what you need to grow.
What is working capital?
Working capital is an important measurement of your company’s efficiency and short-term financial health. When you have enough working capital, you can easily pay your financial obligations including salary, rent, loan payments and bills. The formula to calculate working capital is simply current assets minus current liabilities:
- Current assets are cash and resources that can be turned into cash within a year, like inventory and accounts receivable.
- Current liabilities are financial obligations that must be paid off within a year, like payroll, taxes, accounts payable and most bills.
We like to think of working capital as fuel for a small business. When a car has a full tank of gas, it can drive for miles. But when the tank nears empty, the car starts to sputter and stall. Similarly, a business needs enough working capital to operate smoothly. With enough working capital, a company can go far and take on more customers, projects, and immediate growth opportunities. However, if working capital runs dry, a business will struggle to cover every day expenses and growth will stall out.
Fueling the working capital cycle
When your company makes a sale, it can often take time for the customer to pay and provide you with cash. For companies that sell products, it can also take time to sell your inventory and receive cash. This creates a working capital cycle for small businesses:
- Step 1: Inventory is purchased or services are sold
- Step 2: Customers pay for products/services
- Step 3: The company uses this cash received to pay bills and other expenses and the cycle is repeated
Sometimes, there’s a delay between steps 1 and 2 that can lower the amount of available working capital—the gas in the tank starts running dry. The faster a company grows, the more fuel it needs and this cash flow timing issue can become an even bigger problem. Therefore, growing businesses often need “permanent” working capital, or a minimum amount of cash to pay for ongoing operations associated with their growth. Permanent working capital is like having an extra tank of gas in your trunk that you can use to fill up when you are running low. It allows you to always be able to access the money needed to pay bills, without having to wait for income from sales to turn into cash.
How to create working capital
There are lots of tips for business owners looking to increase working capital. Reducing stock, invoicing promptly, tightening credit terms, and providing early or on-time payment incentives are all effective tactics.
However, these methods typically won’t create enough working capital to support rapid growth. For example, if a construction company wins a $1 million contract when its typical sale is $250,000, payments coming in from previous work won’t cover the cost of raw materials, new employees, and other upfront expenses required for the new job. Similarly, if a retail store is opening a second location and needs to fully stock it, the cash generated from current sales won’t cover a large inventory purchase.
For rapidly growing companies, well-structured small business loans are an excellent source for the permanent working capital required. While many information sources will point small business owners to lines of credit for working capital needs, we more frequently recommend term loans, including SBA 7(a) loans. That’s because the need for working capital is often long-term, and lines of credit are best suited for short-term expenses that can be paid back quickly. In fact, if a line of credit is not paid back in time because the business needs the money for longer, the lender can increase the interest rate which will hurt the business’s financial standing.
The bottom line: if you’re growing, check in with your lender to learn more about your working capital needs
Working capital is critical for small business success. If you’re anticipating a growth spurt, it’s a good time to check in with a small business lender to understand what your loan options are to fund the increase in permanent working capital that you’ll need. At Grow America, we offer a number of loan programs that can provide you with affordable working capital.
Remember—working capital is the fuel that keeps your business moving. Having enough working capital can make the difference between a struggling business and one that’s well-positioned for long-term success. Contact us today for a free one-on-one consultation with a small business lender who can help you understand your working capital options, we’re happy to help!