Being a small business owner and successfully managing your balance sheet is a lot like being a juggler. Entrepreneurship can be an exhilarating rush, but there are a lot of moving parts that you or your team will need to manage well if you want to be successful. How to find working capital is a challenge for a lot of small businesses, but doing it successfully is the lifeblood of your business.
One important area that you have to stay on top of as a business owner is working capital management, or making sure your company has the required working capital to operate. It doesn’t matter how many tasks or responsibilities you’re juggling either. This is one job you can’t afford to overlook if you want to maintain your business’s financial health.
How to Find Working Capital
If you want to increase working capital, either to solve a pressing cash flow challenge or to free up money so your business can take advantage of an opportunity, it helps to know your options. Naturally, you can take out a working capital loan, and that’s something we will cover, but working capital financing isn’t the only way to find extra capital.
Here are five potential ways you may be able to find working capital for your business.
1. Save more profits to reinvest
There’s arguably no better way to find working capital (or to fund future business investments) than to squirrel away a portion of your profits. Your business plan should always include some kind of savings so you can have cash in reserve.
Having money in reserve gives you cash on hand to cover costs like:
- Equipment upgrades, repairs, or replacements
- Marketing expenses
- Investment opportunities
- Unexpected expenses and payments on short-term debts
Don’t forget, cutting expenses may help you to increase your profits and stretch your company’s working capital even further. By keeping a close eye on spending and making reductions where you can, your business might generate even bigger profits that you can turn around and reinvest in better ways.
2. Get a working capital loan
One way to secure working capital when you need it fast is to take out a working capital business loan. This type of business financing generally is not used for investments or other long-term purposes. Rather, working capital loans can help your business get through a cash flow emergency or may help you to take advantage of short-term investments that have a high potential of turning a profit quickly.
Looking into small business loans for working capital? The following options may be worth exploring.
You may need to increase your business credit scores before you can secure a loan, however. In that case, another faster option is looking into business credit cards. This helpful guide can also help you to discover other funding options that might be a good fit for your business.
Crowdfunding may be a less common way to raise capital for your business, but it’s an option that has worked well for many business owners. In fact, many larger businesses are using crowdfunding to even validate a new product — or introduce new products to the market.
At the most basic level, crowdfunding is a form of fundraising businesses can use to generate income without borrowing. Crowdfunding could potentially be a good fit even if you have a less-than-perfect credit profile because the crowd will respond to the strength of your idea, not your personal or business credit history.
Before you get too excited at the idea of “free money,” there are some drawbacks of crowdfunding that you should consider as well.
- Crowdfunding campaigns typically require a lot of work on the business owner’s side (that’s you). You’ll have to convince people to contribute to your business idea. You will likely need to offer them something in return (e.g. a pre-sale, a free product, elite status, etc.). And, you’ll have to keep the momentum going throughout the campaign. Many business owners report that it can be a very time-consuming process.
- If you don’t reach your financing goal, with certain crowdfunding platforms you might not get any of the funds you did raise.
Nonetheless, crowdfunding has been a very successful way for many businesses to raise much-needed working capital. If you’re looking for specific crowdfunding options, this helpful guide might be a good place to start your research.
4. Raise capital by selling equity
Another common way that small business owners raise money is by selling shares in their companies. The way it works is that you accept an equity investor’s money in exchange for partial ownership of your company. This process is known as equity financing.
Equity financing is often used by startups as a way to help cover the initial costs to get a business off the ground. However, it’s also used by existing businesses as well, often as a means of raising capital to be used for investments, expansions, or other opportunities for growth.
Equity investors are usually looking for a business that can exponentially grow with the infusion of additional capital. These investors may not be looking for a periodic payment, but they are looking for what’s called an equity event (an IPO or sale of the company) to recoup their investment in your and your business.
To be a good fit for an equity investor, your business needs the potential to scale with the investment of additional capital. In other words, the goal here is to grow your business quickly to position it for an Initial Public Offering in the stock market for acquisition.
Investors interested in purchasing equity in your business might be found among any of the following groups:
Equity financing can indeed be an effective way to raise working capital for your business. But it’s important to count the cost before you make any final commitments.
Do you mind sharing control of your company with someone else? Most equity investors will want a seat at the decision-making table to help you guide your business toward the equity event mentioned above. If you don’t like that idea, or are more interested in building a legacy business you can pass down to your children, this might not be the best fit for your goals. You may want to find a different way to raise working capital for your business.
5. Trade credit
Finally, don’t underestimate the power of trade credit (also known as vendor credit) when you need to overcome working capital challenges. It may not technically be a working capital loan, but 30-, 60-, or 90-day terms can be a powerful way to access funds for working capital. For certain types of businesses, this can be the perfect solution to cash flow challenges (or at least an important piece to help solve the puzzle). And it’s often available simply for the asking.
Let’s say you’re a retailer and you need to increase production of certain products prior to your busy season. If you find suppliers that are willing to extend terms, you may be able to secure the materials you need to create your products now, and pay for those materials at a future date. Assuming the due date is far enough into the future, you’ll have time to create your products, sell them, and collect on those sales. Trade credit could be a great solution to help secure the supplies you need upfront without immediate cash in hand.
What Is Working Capital?
Let’s define working capital.
Working capital is the money left over after your business has paid for all of its debts and liabilities. In other words, it’s the cash that isn’t tied up in day-to-day operations and debt obligations. Another way to describe working capital is that it’s a measure of your company’s liquidity at a given point in time. It’s one metric that investors use to decide whether your business is healthy and profitable — and it’s essential for you to keep track of if you want to make sure your business is profitable.
You can figure out how much working capital your company currently holds by adding up your business’s current liabilities and subtracting them from your business’s current assets. (See more information on finding these figures below.)
Advantages of Working Capital
There are many advantages of working capital management. Having a positive working capital means you have enough cash to invest and grow your business. You aren’t struggling to meet your financial obligations or short-term liabilities. But that doesn’t mean you want your working capital to skyrocket. Having too high of an amount of working capital could mean your inventory turnover is taking too long, you aren’t investing your extra money well, or you aren’t taking financing opportunities that can help your business succeed.
How Working Capital Affects Cash Flow
Cash flow and working capital are interconnected parts of your business’s finances, but they show up on two separate financial statements. Cash flow shows up on a business’s cash flow statement and working capital shows up on a company’s balance sheet. For example, buying a big-ticket item will decrease both the cash flow and the working capital because it decreases the amount of cash a company has on hand. On the other hand, selling a liquid asset would increase both working capital as well as cash flow.
Working Capital: The Quick Ratio and Current Ratio
There are two financial ratios you can use to calculate working capital: the current ratio and the quick ratio. They are both useful in showing you your business’s liquidity, but they play different roles. The quick ratio looks at more short-term liquidity while the current ratio is more helpful when you’re looking at the long-term picture.
To do this, the current ratio looks at current assets (like accounts receivable, cash, and inventory) and current liabilities (like short-term debts and accounts payable) that you must pay within a year.
The quick ratio, on the other hand, looks at a specific point in time using the most liquid assets a business has on hand. In this way, it helps you look at a business’s ability to cover short-term debts. So it only considers current assets that could go through short-term liquidity, or be converted to cash within 90 days. It’s one way to consider the short-term financial health of your business.
In the next section, we use the current ratio to calculate working capital.
Working Capital Formula
Current Assets – Current Liabilities = Working Capital
Working Capital Ratio Formula: How to Calculate Working Capital
Before you can calculate your business’ working capital ratio, you’ll need to gather some important data. Namely, you need to be able to answer the following questions:
- What is the total amount of your company’s current assets that are in cash or can be converted to cash in the next 12 months?
- What is the total amount of your company’s total liabilities with payments due in the next 12 months?
Although these questions may not seem overly complicated on the surface, you might be surprised. If you don’t calculate these two important figures properly in the beginning, you’ll never be able to figure out your real working capital ratio.
For working capital calculation purposes, your current assets include cash or resources that can be turned into cash within the next 12 months. These might include:
- Cash Equivalents
- Accounts Receivable (aka Outstanding Invoices Owed to Your Company)
- Marketable Securities
- Prepaid Expenses
- Other Resources That Can Be Converted to Cash
Current liabilities, at least for the purpose of working capital formulas, can be defined as the amount of money your business owes (aka payments are due) within the next 12 months. Any of the following might be considered as a current liability:
- Short-Term Loans/Debt
- Payments Due on Long-Term Loans/Debt During the Next 12 Months
- Accounts Payable
- Other Expenses (Wages, Taxes, Supplies, Etc.)
Now that you have the right figures to work with, it’s fairly simple to plug them into the formula which is used to calculate your working capital ratio.
Working Capital Ratio Formula
Current Assets ÷ Current Liabilities = Working Capital Ratio
How to Calculate Working Capital with Example
Here’s an example of how the working capital ratio formula works.
|Current Assets||Current Liabilities|
|Total: $200,000||Total: $130,000|
Next, you take the business’ total current assets and divide it by its total current liabilities.
$200,000 (Current Assets) ÷ $130,000 (Current Liabilities) = 1.5 (Working Capital Ratio)
What Ratio Is Best?
The idea ratio of assets to liabilities is 3:1. In other words, Three times as many assets as liabilities. Although this can be a challenging ratio of many small businesses, if the ratio gets below 1:1, it’s telling you that it’s costing you more to do business than what you’re earning—even if you have cash in the bank at the end of the month.
If the ratio falls below 1:1, it means your business has more liabilities than assets. This is known as negative working capital and it signifies that your business may not have the money to cover what it owes.
A ratio over 1, on the other hand, demonstrates that your business has more assets than liabilities. This is called positive working capital. It means your company is breaking even, or better. The 3:1 ratio demonstrates to a lender that you have adequate working capital (or cash flow) to meet periodic payments; provided the new payment obligation won’t bring your ratio down below 1:1.
Regardless of your business goals, it’s important to maintain a healthy working capital ratio. Too little working capital can mean that your business may have trouble paying its daily, weekly, and monthly expenses. You might not believe it, but having too much working capital could potentially be a bad thing as well. If you hold on to your business’ profits too tightly, it might be a sign that you’re not reinvesting money into your company like you should.
So what working capital ratio should you aim for with your business? There are some different opinions on the subject. However, a number of lenders and accounting pros agree that a ratio somewhere between 1.2:1 and 3:1 is generally considered acceptable, but 3:1 is considered optimal.
Positive vs Negative Working Capital
Positive net working capital means your assets outweigh your liabilities, so you have enough to cover your operating expenses, short-term obligations, and long-term debt while also investing in the future of your business. It’s a sign of good financial health in a business.
However, having negative working capital for an extended period can signify that your business is struggling to pay what it owes and also invest in the business’s success. This situation could lead to default on repayment or, worst case scenario, bankruptcy.
Also, having negative working capital could make it much more difficult to bring on investors, if you’re interested in that, or get approved for small business financing. Lenders like to see that your business is profitable so you’ll be more likely to be able to pay back your debts.
Working Capital Requirement Formula
In addition to knowing your business’ current working capital ratio, it’s also important to calculate how much working capital your business needs to operate at a successful level. To find this figure for your company, you can use the working capital requirement formula.
Working Capital Requirement Formula
Inventory + Accounts Receivable – Accounts Payable = Working Capital Requirement
If done correctly, this cash flow analysis can help you to answer the question, “How much money does my business need to operate?” Again, though this formula may look simple enough on paper, remember that getting the correct answer requires that you be especially careful to start with the right figures.
Finally, you can’t calculate your business’ working capital requirement one time and think your job is done. Rather, your working capital requirement is typically a more fluid concept. Internal and external forces can cause this number to fluctuate. Depending on your working capital cycle, today’s answer might not be enough money to keep your cash flow in the positive tomorrow. If you really want to maintain a positive new working capital, this is a calculation you’ll have to regularly monitor and update frequently.
The Bottom Line
Even if you’re a business pro who has successfully been managing cash flow for years, it’s wise to keep some money in reserve for unanticipated challenges and expenses. Consider it an emergency fund for your business.
It’s also smart to keep your credit (both personal and business) in the best shape possible. If you anticipate a small business loan to borrow money in the future, your lender will check your credit profile as part of your application. You can check and monitor your business and personal credit with a free Nav account.
Remember, building a great credit profile doesn’t happen overnight. It takes time and effort. If you have ignored your business credit profile, you can and should work to establish business credit now, before you need it. You might not plan to borrow money for your business in the near future, but having great credit in reserve can be a very valuable asset.
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