How to Increase Working Capital (And Why You Should).
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Working capital is the lifeblood of any business, as it is the funds available to meet short-term financial obligations and daily operational expenses. Ensuring that a business has enough working capital is crucial to its success, growth, and financial stability.
Defining Working Capital
Working capital is a metric that measures the difference between a company’s current assets and current liabilities. Current assets are short-term assets that can be converted into cash within a year, such as cash, accounts receivable, and inventory.
Current liabilities are short-term obligations that must be settled within a year, including accounts payable, short-term debt, and other financial obligations. The net working capital measures a company’s liquidity, efficiency, and overall financial health.
How to Calculate Working Capital
To calculate a business’s amount of working capital, you must subtract a company’s current liabilities from its current assets. You’ll want to examine your business’s financial statements and other documents. Here’s an example:
Let’s assume Trucking Company ABC has the following financial information on its balance sheet:
Current Assets:
Cash: $50,000
Accounts Receivable: $30,000
Inventory: $20,000
Current Liabilities:
Accounts Payable: $25,000
Short-term Debt: $10,000
Other Current Liabilities: $5,000
Now, to calculate the working capital, follow these steps:
Add up the current assets: Cash ($50,000) + Accounts Receivable ($30,000) + Inventory ($20,000) = $100,000
Add up the current liabilities: Accounts Payable ($25,000) + Short-term Debt ($10,000) + Other Current Liabilities ($5,000) = $40,000
Subtract the current liabilities from the current assets to find the working capital: Working Capital = Current Assets – Current Liabilities Working Capital = $100,000 – $40,000 Working Capital = $60,000
In this example, this company’s working capital is $60,000. That’s a fantastic amount of positive working capital for a company of this size.
This means the company has enough short-term assets to cover its short-term liabilities ($40,000), which is a positive sign for its financial health and liquidity. In fact, having more current assets than current liabilities is known as having positive working capital. That would be known as negative working capital if the opposite were true.
The Importance of Working Capital
A healthy working capital position is vital for a business as it ensures that it can meet its day-to-day expenses, such as paying suppliers, employees, and other operational costs. Insufficient working capital can lead to cash flow problems, making it challenging for a business to operate smoothly and grow.
Sufficient working capital is essential for small businesses’ smooth operation and growth. Here are some of the key benefits of maintaining an adequate level of working capital:
Ensures smooth operations: Having enough working capital ensures that a business can cover its day-to-day expenses, such as purchasing inventory, paying suppliers, and covering payroll. This allows the business to operate efficiently without disruptions caused by cash flow issues.
Enables growth and expansion: Adequate working capital allows small businesses to invest in growth opportunities, such as launching new products or services, expanding to new locations, or increasing marketing efforts. These investments can lead to increased sales and revenue, driving further growth and success.
Enhances creditworthiness: Lenders and investors generally view businesses with sufficient working capital as more financially stable. This can make it easier for a business to secure financing or attract investment when needed and potentially secure better credit terms with suppliers.
Provides a financial cushion: Adequate working capital provides a safety net during economic downturns or unexpected events, such as a sudden drop in sales or an unforeseen expense. A healthy level of working capital allows businesses to weather these challenges without resorting to costly financing options or risking insolvency.
Improves supplier relationships: When a business has sufficient working capital, it can pay its suppliers on time or even take advantage of early payment discounts. This can lead to stronger relationships with suppliers, which can be particularly important for small businesses that rely on a limited number of suppliers for their inventory or raw materials.
Facilitates better cash flow management: Sufficient working capital allows businesses to manage their cash flow more effectively, enabling them to optimize the balance between accounts receivable and accounts payable. This can help reduce the risk of cash flow issues and ensure the business remains financially stable.
Supports customer satisfaction: When a business has adequate working capital, it can invest in initiatives that improve customer satisfaction, such as enhancing product quality or providing better customer service. Happy customers are more likely to become repeat customers and recommend the business to others, contributing to the company’s long-term success.
Dangers of Insufficient Working Capital
A business with insufficient working capital may struggle to meet its financial obligations, leading to late payments, damaged credit ratings, and strained relationships with suppliers and creditors. It can also hinder a business’s ability to invest in growth opportunities, such as expanding its product line or entering new markets. In extreme cases, a lack of working capital can result in bankruptcy or insolvency.
Strategies to Increase Working Capital
Working capital improvement means giving your company financial maneuverability over the long term. Improving any of these factors goes a long way toward improving your business finance health overall.
Improve Accounts Receivable Management
Managing accounts receivable is crucial to maintaining healthy cash flow and increasing working capital. Implementing stricter credit policies and offering incentives for early payments can help reduce the time it takes to collect payments from customers. Additionally, regularly reviewing accounts receivable aging reports and following up on overdue accounts can help minimize bad debts and improve cash inflows.
Optimize Inventory Management
Efficient inventory management can free up cash that’s tied up in excess stock. Implementing inventory management techniques such as just-in-time (JIT) inventory or using inventory turnover ratios can help reduce inventory carrying costs and improve working capital. Regularly reviewing stock levels and demand forecasts can also help businesses avoid overstocking or stockouts.
Negotiate Better Payment Terms with Suppliers
Negotiating favorable payment terms with suppliers can help extend the time it takes to pay accounts payable, improving cash flow and increasing working capital. By extending payment terms, businesses can hold onto their cash for longer periods, allowing them to better manage their short-term financial obligations.
Obtain Working Capital Financing
Working capital financing refers to the various financial tools and options available to businesses to help manage their short-term financial needs and maintain healthy cash flow. This type of financing is crucial for businesses to ensure they can cover day-to-day operational expenses, such as purchasing inventory, paying suppliers, or covering payroll. Many of these forms of financing function well as working capital, and some will be more available to businesses with good credit than those with bad credit.
There are several types of working capital financing options, both loans and alternative financing, that businesses can utilize to meet their short-term financial requirements:
Line of Credit: A business line of credit gives businesses access to a predetermined amount of funds that can be used as needed. Like a credit card, businesses only pay interest on the funds they use, and once the borrowed amount is repaid, the credit line is replenished. This flexible financing option is ideal for businesses with seasonal or fluctuating cash flow needs.
Short-term Loans: Short-term loans are provided by banks, credit unions, or online lenders and typically have a repayment term of 12 months or less. These loans can be used for various purposes, such as covering temporary cash flow gaps or funding small-scale projects.
Invoice Factoring/Financing: Invoice factoring or financing involves selling a business’s outstanding invoices to a factoring company at a discount in exchange for immediate cash. This can help improve cash flow by providing the funds needed to meet short-term expenses without waiting for customers to pay their invoices.
Merchant Cash Advances: A merchant cash advance (MCA) is a financing option for businesses that receive a lump sum advance in exchange for future revenue. MCA’s are not business loans. This option can provide quick access to working capital and less strict eligibility as providers care more about reoccurring revenue than your credit score.
SBA Loans: The Small Business Administration (SBA) offers various loan programs designed to help small businesses obtain financing. Some SBA loans, such as the SBA 7(a) loan program, can be used for working capital purposes. These loans often have favorable terms and interest rates, but the application process can be more complex and time-consuming.
By leveraging one or more of these working capital financing options, businesses can maintain adequate liquidity, cover short-term expenses, and invest in growth opportunities. It is essential for business owners to carefully assess their financial needs and choose the most suitable financing option based on their specific circumstances and goals.
Improve Pricing Strategies
Businesses can increase their profit margins by analyzing and adjusting pricing strategies, leading to increased cash flow and working capital. Regularly reviewing pricing structures and market trends can help businesses identify opportunities to optimize their pricing and improve their financial position.
Conclusion
Solid working capital management is vital for a business’s financial health and growth. By implementing strategies such as improving accounts receivable management, optimizing inventory management, negotiating better payment terms with suppliers, obtaining working capital financing, and improving pricing strategies your business can thrive.
