What is Working Capital & How is It Used?
Working capital is the cash that the company uses to finance its expenses, such as rent, labor, suppliers, bills, and many more. Working capital is an essential financial metric since it shows the extent of the company’s operational efficiency.
Research shows that 29% of startups fail due to inadequate working capital. Therefore, as an entrepreneur, it crucial to have adequate working capital to avoid the unnecessary failure of your business.
Working capital can be classified into two parts – gross working capital and current working capital. Gross working capital encompasses all the business’ currents assets, such as cash, account receivables, marketable securities, inventory, and short-term investments. Net working capital is the difference between gross working capital and current liabilities.
Working capital can also be referred to as net current assets. Current liabilities are business obligations that are supposed to be settled within a year, and they include accounts payable, accrued expenses, interest payable, tax payable, and bank overdraft.
How to Calculate Working Capital
Working capital can be computed by subtracting current liabilities from current assets. If the difference is positive, then it implies that you have enough funds to grow and expand your business. However, if it is negative, it means that you don’t have sufficient money to finance your expenses, and your business may be facing liquidity risk.
About Working Capital Ratio
The working capital ratio is a financial parameter representing the liquidity of a business entity. You can determine the extent of your business’ liquidity by calculating the working capital ratio. You can get this ratio by dividing the total current assets with current liabilities.
If the ratio is at least one, you have sufficient funds, and if it is less than one, you have inadequate funds, and your company owes more money than it makes. The following is the formula for calculating the working capital ratio.
Types of Working Capital Loans
If you want the operation of your business to go uninterrupted, it is critical to maintain sufficient working capital. The following is a highlight of some of the best sources of working capital loans.
- Short Term Loan
A short term loan is a credit facility that is payable within one year, and it is meant to boost your working capital. Through this loan, you can quickly fund your daily business needs and enhance efficiency in your entrepreneurial operations. You can obtain short-term loans from banks, micro-finance institutions, and credit unions.
Usually, short term loans carry a fixed rate of interest and are disbursed into customers’ accounts as a lump sum. Before you borrow any loan, it is vital to find an institution that offers the most affordable rates to avoid paying high charges.
Sometimes, short-term loans are secured to mitigate them against default risk. The type of security required is based on the loan amount, your credit history, and your ability to pay. However, if you have an excellent credit record, banks may grant you an unsecured credit to help you keep your business operational.
Short-term loans are not only meant for businesses but can also be used for personal use. For instance, if you need money to pay hospital bills, you may borrow from a bank and pay it back in manageable monthly installments.
A quite number of businesspeople prefer working capital loans to other credit facilities because of the following reasons. First, they are approved fast, meaning that you can access them within hours or days. Second, working capital loans are paid within a short time; hence the interest payable is less. Third, they are convenient to acquire and flexible to pay.
- Bank Overdraft
A bank overdraft is a loan granted by a financial institution to a customer payable by the next credit (deposit) that will be available in the client’s account. Under this arrangement, you are allowed to overdraw your account based on several factors, such as your ability to pay and collateral.
Unlike other credit products, with overdrafts, you only pay interest, and you don’t incur some costs, such as loan processing fees. It’s also crucial to note that the interest paid on overdrafts is lower than that paid on other facilities, such as credit cards.
Bank overdrafts can help you meet your short-term obligations, hence making your business operate with minimal disruptions. For example, through this facility, you can pay your bills promptly and maintain a good relationship with your suppliers and other service providers.
As an entrepreneur, you also need to understand what is meant by overdraft protection and how important it is to your business activities. For your information, overdraft protection is an option where banks ensure that your debit transactions don’t make your account have less than zero balance. Also, through overdraft protection, no overdraft fee is triggered during the sale.
With overdraft protection, banks will bridge the deficits in your account and process your transactions, such as electronic transfers, ATM withdrawals, and check payments. Under this approach, you are charged a unique cost, which is referred to as overdraft fee, to ensure that your transaction is completed successfully.
- Invoice Financing
Invoice financing entails a situation where a business entity borrows money from a financial institution against its account receivables. Through this source of funding, your business can get immediate cash to pay suppliers and bills, and reinvest to expand its operations.
To get invoice financing, you have to pay a specific proportion of your account receivables as a fee to the lender for the credit granted. If you are experiencing delayed payments from your customers, you can opt for invoice financing.
The cost of invoice financing varies from one lender to another. Therefore, before you settle on any particular financier, it is vital to get and compare many quotes from different service providers to make an informed decision.
- Small Business Administration Loans
Small Business Administration (SBA) is a government agency based in the US, and it is one of the sources of working capital to many businesses in the country. SBA doesn’t only finance enterprises but also offers them financial literacy and advisory services to prepare them to succeed in their endeavors.
It is vital to note that SBA doesn’t lend you money directly, but it works with a group of lenders to help you get credit services. To get an SBA loan, you must go through these steps. First, you have to fill in a questionnaire regarding your business. Second, you will be matched with appropriate lenders and then receive a response from them via email; third, contact lenders to compare their rates; and finally, apply for your business loan.
Before you contact lenders for SBA loan, you have to meet the minimum requirements, such as having an updated business plan, being knowledgeable about your business budget and its capital requirements, having a good credit score, and possess collateral.
Although SBA doesn’t give direct loans to businesses, it guarantees to pay lenders any amount that their beneficiaries may default. Also, manageable installments characterize these loans because they can be paid on a long-term basis.
- Business Line of credit
A business line of credit is a source of working capital whereby a customer borrows money from a financial institution based on the preset limit. Under this arrangement, you can borrow as much as you want until you reach a specified threshold. It is essential to note that the amount granted can be paid back and acquired again.
With the business line of credit, the lender determines the loan size, rate of interest, and repayment period based on the characteristics of the borrower. A line of credit can be secured or unsecured. If you want to pay a lower interest in this facility, it is advisable to opt for the secured one.
A business line of credit is characterized by flexibility. This implies that you can apply for a specific limit, but you don’t have to utilize it at once. Therefore, you only pay interest on the amount you withdraw but not on the aggregate limit. Also, as a borrower, you are at liberty to either pay the outstanding credit balance or continue paying based on the minimum installments.
As an entrepreneur, you should bear in mind that the more you utilize the line of credit and make prompt payments, the higher the likelihood of getting more limits at lower interest rates. Therefore, if you want to better your future source of working capital, you must adopt a discipline of timely payment.
In order to enhance the higher chances of getting a suitable limit, you should apply for a line of credit when your business is thriving. However, banks might decline to offer you this facility if you make an application when your company is underperforming.
- Merchant Cash Advances
A merchant cash advance is a financing option whereby business owners get funds from advance providers and pay for the money from the proceeds of their daily business sales. Merchant cash advances are ideal for entrepreneurs who are paid through cash, checks, and credit cards. Moreover, if your sales volume is high, and you are not eligible for a bank loan, then you can opt for this type of facility.
Through merchant cash advances, you can get financed in exchange for a proportion of your business income (e.g., credit card transactions) over a particular time. Once you get this capital, you are supposed to make daily payments based on the percentage of daily credit card revenues.
Merchant cash advances are a convenient means of getting immediate working capital for your enterprise. The application process for this facility is straightforward, and it can be approved and made available to you within a day. Also, unlike bank loans, it is essential to note that getting this facility doesn’t require any collateral.
6 Reasons Why You Need Working Capital Loans
A working capital loan is essential in ensuring that your business activities go uninterrupted. The following is a highlight of the reasons why you need working capital loans.
- To finance unexpected expenses
Sometimes, your business may encounter an emergency, such loss of stocks and equipment breakdown. In such scenarios, your insurance is supposed to pay. However, insurance claims may take a lot of time; hence it is crucial to get a working capital loan to normalize your business activities.
- Seasonal Income fluctuations
Some businesses get inconsistent revenues quarterly because they are affected by different seasons of the year. For instance, if you are in the hospitality industry, you are likely to report more income during the fourth quarter since it falls within the December holidays. However, during other quarters, such as the first one, you are likely to get a few clients, hence getting inadequate income. Therefore, under these circumstances, getting a working capital loan to finance your operations will be inevitable.
- Business expansion
While doing business, growth opportunities may arise unexpectedly, especially when you don’t have sufficient cash. For instance, you may encounter someone selling a vital business asset, or you may get a new business location for your company. Under this situation, you can only seize the opportunities if you have adequate funds.
- Purchase inventories
Having adequate working capital can make you acquire business stocks when they are sold at affordable prices. Sometimes, you may encounter rare items being offered at discounts. Therefore, working capital can make you buy them at discounted prices, enabling you to make more profits.
- Irregular cash flow
Some invoices, especially the service ones, take time to get paid. If you are in the service industry, you may find it challenging to obtain payments from your clients due to various reasons. For instance, some customers may delay paying because of financial constraints. Therefore, in such a scenario, you would need working capital to fund your activities.
- Buying equipment
Sometimes, you may need specific equipment, such as computers, printers, and photocopiers for the operation of your business. In this case, you can opt for asset finance, and pay it on a short term basis. Under this arrangement, the equipment you buy will act as collateral.
Final Thoughts on Working Capital
Working capital is an essential financial metric reflecting the liquidity of your business. As an entrepreneur, you need to be aware of your working capital ratio at all times. If you realize that the ratio is less than one, then you need to understand that you owe more money than you make. However, if your ratio is more than one, it implies that you have adequate funds for operating and expanding your enterprise.
You can get your working capital from various sources, such as bank overdrafts, SBA loans, invoice financing, short-term loans, and many more. It is crucial to note that before you opt for any type of loan, you should compare various quotes and select the cheapest lender.
Also, note that the majority of working capital loans are paid on a short-term basis, and, therefore, it is advisable to strategize on how to pay them promptly to enhance your creditworthiness.
Working capital can help your business remain operational with minimal interference. For instance, through it, you can pay unexpected expenses, salaries, and rent. Also, through working capital, you can grow your business by adding more inventories or opening new branches.