Being a small business owner is a lot like being a juggler — if that juggler is handling a dozen spinning, double-ended torches that have been lit on fire. In all seriousness, being an entrepreneur can be an exhilarating rush. Still, there are a lot of moving parts that you or your team will need to manage well if you want to be successful.
One important area that you have to stay on top of as a business owner is making sure your company has enough 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.
What Is Working Capital?
Before we dive into some different ideas about how to find the working capital your business needs, let’s start with a definition of working capital. Even if you’re not familiar with the term itself, as a business owner you’re probably very familiar with the concept.
Working capital is the money your business uses to operate and cover its financial obligations. It’s how your business pays for its day-to-day expenses like payroll, supplies, taxes, and rent. Another way to describe working capital is that it’s a measure of your business’ liquidity at a given point in time.
You can figure out how much working capital your company currently holds by adding up your business’ current liabilities and subtracting them from your business’ current assets. (See more information on finding these figures below.)
|Working Capital Formula|
|Current Assets – Current Liabilities = Working Capital|
How to Find Working Capital
If you want to increase your working capital, either to solve a pressing cash flow problem 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 you would be incorrect to think borrowing is the only way to find working capital.
Read below for 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. When you set aside part of your profits instead of immediately spending them, you can create more financial freedom to reinvest in your business in the future.
Having money in reserve gives you cash on hand to cover costs like:
- Equipment Upgrades, Repairs, or Replacements
- Marketing Expenses
- Investment Opportunities
- Unexpected Expenses
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 to 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 for a working capital loan for your business? The following options may be worth exploring.
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. At the most basic level, crowdfunding is a form of fundraising campaign that businesses can use to generate income. If your money-raising goal is on the smaller side, a crowdfunding platform could potentially be a good fit.
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 donate. You might have to promise 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 that you did raise.
Nonetheless, crowdfunding has been a very successful way for some businesses to add much needed working capital to their bank accounts. 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 someone else’s money and you hand over partial ownership in your company in exchange. 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.
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? If you don’t like that idea, it might be best 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. For certain types of businesses, this can be the perfect solution to cash flow woes (or at least an important piece to help solve the puzzle).
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 that you’ll have time to create your products, sell them, and collect on those sales, trade credit could be a great solution to help you secure the supplies you need upfront without immediate cash in hand.
Working Capital Ratio Formula
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.
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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
- Payments Due on Long-Term Loans 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?
When your ratio falls below 1 (or 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 will have an easier time paying its obligations and can signify to lenders that choosing to do business with your company is a better risk.
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 and 2 is generally acceptable.
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. Today’s answer might not be enough money to keep your cash flow in the positive tomorrow. If you really want to stay on top of how much money your business needs to operate, this is a calculation you’ll have to make over and over again.
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 changes and expenses. Think of it like an emergency fund for your business.
It’s also smart to keep your credit — both personal and business — in the best shape possible. If your business wants to borrow money in the future, there’s a good chance a lender will check your credit score as part of your application. You can check and monitor your business and personal credit with a free Nav account.
Remember, a great credit rating doesn’t happen overnight. It takes time and effort. 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.
Ready to see your credit data and start building better business credit? Check Your Personal and Business Credit For Free (No Credit Card Required).