What is Working Capital & Why is it Important for Business?
6/29/2022 - By Mark Schuch - Commercial Stories and Insights
You’ve worked hard to operate your business, serve your customers well and build a team of professional employees.
Is your next step to grow the company using working capital? What are other ways to use working capital to the benefit of your business?What is Working Capital?
Think of net working capital similar to current assets. It’s the difference between your short-term assets – cash on hand, receivables and raw materials – and current liabilities – accounts payable, expenses and debts.How Much Working Capital Does My Business Need?
Understanding your working capital gives you a picture of your operational efficiency and short-term financial health. Companies with surplus working capital can invest and grow. If their working capital is in the red, however, they may not be able to pay their creditors or employees.Companies should strive to have a balanced working capital. Those with too much may not be investing enough, while a company with a negative working capital needs to increase cash flow.
Your business should aim to have a working capital ratio between 1.2 and 2 because this means the company is in a healthy state to pay its liabilities. A number below 1.0 is referred to as negative working capital, which indicates that a company cannot pay its current liabilities. A number above 2.0 means that the company has idle funds which are not being invested wisely.
How to Calculate Working Capital Ratio
To calculate your company’s current working capital ratio, you’ll need to divide current assets by current liabilities. The following are some examples of short-term assets and liabilities:
- Short-term assets such as cash in business accounts, accounts receivable and inventory that you anticipate will be converted to cash within 12 months.
- Short-term liabilities include accounts payable, employee salaries, taxes and money owed to creditors
Common Reasons a Business Needs Additional Working Capital
Additional working capital may mean you’ve had a period of good revenue, but most business owners know lean months are a reality as well.
You may want to put some available capital aside to cover any shortfalls or unexpected cash flow problems in the future. Positive net working capital can also help cover gaps in receivables when customers are late on paying you. Although not as prevalent as years past, some suppliers offer discounts for paying early or buying in bulk, so it helps to have extra working capital on hand.
Additional working capital can help you plan ahead. Set aside funds to cover anticipated tax bills or get a jump on paying your annual property taxes.
What Can Working Capital Be Used For?
If your business has a healthy working capital ratio, investing or expanding could be a logical next step. Do you have an eye on a second location? Do you need to hire additional staff?Not all growth has to come from buying more property. Would your business benefit from spending funds on a marketing campaign?
Working capital can also allow you to upgrade equipment through purchase or lease. New machinery could lead to better efficiency and improved employee safety depending on your line of work.
Ways to Boost Working Capital
Boosting your working capital isn’t too different from effective cash flow management. Moving your working capital toward the positive ratio can be accomplished by incentivizing receivables, improving inventory management, working with regular vendors for discounts and automating finances.Business Line of Credit
Your company may benefit from a business line of credit to make the moves you desire. A line of credit offers easy access to funds.With a business line of credit, you can always have easy access to the funds you need to keep your business running smoothly. You can use your credit for seasonal needs or to purchase inventory at a good price, then repay when receivables come in. You’ll only pay interest on what you’ve borrowed.
Business Credit Cards
A business credit card may also serve as a benefit. Some business credit cards offer you the opportunity to build points, earn rewards or earn cash back as you purchase necessary items for your company.Consider carefully which employees will receive one if you plan to have more than one card.
How to Apply for a Working Capital Loan
If your business finds itself in need of a working capital loan, the process doesn’t have to be daunting.Your bank may require collateral and years of good credit history. An established business with these items in their favor may receive a competitive APR.
Want to get started on finding working capital for your business? Contact one of our commercial bankers.
