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What is working capital? Here’s everything you need to know

What is working capital? Here’s everything you need to know

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Whether you’re struggling to grow your business or take advantage of bigger projects, working capital can help. Working capital supports your daily running costs, funds larger projects and can help you remain afloat during even the most trying times. In this article, Daniel Reiter, Editor-in-Chief, FreshBooks, explores everything you need to know about working capital so that you can survive tough economic times and take advantage of those big opportunities when they do arise.

What is working capital (net 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.

You may have also heard the term net working capital. Net working capital is the difference between current assets and current liabilities on your balance sheet. It’s the measure of your company’s liquidity, ability to meet short-term obligations and fund business operations. Obviously, it’s ideal to have more current assets than current liabilities. This would give you a positive net working capital.

Alternatively, gross working capital can be evaluated and calculated, but for purposes here we’re referring to working capital as net working capital.

To fully answer the question ‘what is working capital?’ we need to look at how it’s calculated using the info found right on your balance sheet.

How to calculate working capital

The working capital formula is simple: Subtract current liabilities from current assets. Current assets are cash and assets you can convert into cash within a year (this doesn’t include fixed assets, which are considered long-term assets on your balance sheet). These assets comprise accounts receivable, inventory and short-term investments.

Current liabilities (including accrued expenses or accrued liabilities) are short-term liabilities (debts or accounts) that you need to settle within a year such as accounts payable, overdrafts, sales tax, payroll expenses and wages.

To ensure positive short-term financial health, you should aim to have more current assets than liabilities or positive working capital. If current assets don’t exceed current liabilities, you have a deficit, you might run into cash flow problems and may not be able to pay creditors.

Even a profitable business can struggle. Cash may be tied up in assets such as debtors or raw materials and an inability to convert them back into cash signals weak liquidity.

But even after calculating your working capital, how do you know what amount is suitable? Enter the working capital ratio.

Working capital ratio and what it means

The ratio is a measure of the financial health of your business. The formula is: current liabilities/current assets.
The ratio helps you determine if you have enough operating capital to cover your short-term liabilities, aka debt.

Anything below one indicates negative working capital. Anything above two suggests your business isn’t investing excess working capital and assets and has too much cash tied up in inventory, raw materials or debtors.

A ratio of between 1.2 and two is usually sufficient. A declining ratio over the long-term could be a red flag and should be a reason to take immediate attention. For example, it could indicate that your collections process is slow, which would show in your accounts receivable.

When you need working capital

There are two main scenarios to evaluate your company’s working capital needs:
To keep your business afloat when cash flow is slow.
To fund growth or big projects.

And if you don’t have that working capital, you’ll have to find it or risk possible project failure. You could get a bank loan, but the application process takes a while – and even then, approval isn’t guaranteed.
The solution is to find funding elsewhere.

How to get working capital/address negative working capital

Here are five ways to raise cash quickly and get more working capital:

1.Speed up the collection process
Working capital shortages often arise due to delays in payments from clients. These delays will lengthen your working capital cycle. Your working capital cycle is the time it takes to convert current assets and current liabilities into cash. A longer working capital cycle means money is tied up in current liabilities and current assets for longer.
Your goal is to reduce that cycle and reduce the amount owed in your accounts receivable. One way you can do this is by investing in solutions and strategies to speed up the collection process:
• Track collection time with clients so that you know which clients are the slow payers
• Renegotiate payment terms with existing clients, so they pay you sooner
• Improve your invoicing procedures by investing in tools that help you get paid faster.
• Make payment easy for clients by accepting their preferred payment method, such as credit cards
• Encourage early payment by rewarding and penalising clients
• Include the correct details on the invoice to avoid back-and-forth emails that only delay payment

2. Request a deposit
There’s nothing more frustrating than a project coming to a halt due to a money shortage. Asking for an up-front deposit gives you working capital to cover costs for the duration of the project.
Deposits also minimise the chances of non-payment. You can request deposits via email and have clients pay it to your bank account.

3. SBA loans
SBA loans are loans that the Small Business Administration guarantees. Instead of offering these loans, the SBA reduces the risks for banks through a guarantee.
These loans are ideal for long-term working capital requirements. Although they provide a safety net for big projects, the approval process takes time and you have to meet strict requirements:
• You have to be in business for two years or more
• You need a credit rating of more than 680 to show you can pay off the loan
Nevertheless, they’re worth pursuing as interest rates are low and usually between 6-8%. I say “usually” because the SBA also offers disaster loans at lower interest rates.

4. Invoice financing
You shouldn’t confuse invoice financing with traditional factoring. With conventional factoring you enter into long-term agreements, fees are high and they’re intrusive (the provider contacts your clients).
However, with invoice financing, you sell unpaid invoices to a third party and get the cash immediately. You pay interest against the invoice value with interest rates starting as low as 2.5%.
Working capital watch-outs
There are various lending practices you need to be aware of and sources of funding you should avoid that try to take advantage of a company’s working capital problems.

Beware of hidden fees

Often the advertised cost of the funding is not the actual cost. Many lenders charge hidden fees such as subscription and inactivity fees.

Avoid large lines of credit you don’t need

Make sure you don’t over-finance. Many businesses get larger and larger lines of credit, when, in fact, they only need a little.

Avoid financing new customers with revenue from old ones

Many small business owners use the revenue from a past customer to finance the next customer. If you do this often, you can quickly run into cash flow problems.

Key takeaways on working capital

Working capital is crucial for your day-to-day, funding your business growth and helping you out during tough economic times.
That’s why it’s vital to get to grips with it: Understand what it is, learn how to calculate it with the working capital formula and know where to get funding.
How you go about it will depend on your business requirements. You may need to speed up collection procedures, request an upfront deposit, apply for a short or long-term loan or use invoice factoring.
Whatever you decide, rest easy knowing you have working capital to grow during the good times and survive during the tougher times.

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