In this article:
- How to measure working capital
- How working capital loans benefit small businesses
- Types of working capital loans
- Where to get a working capital loan
Working capital describes the amount of money available to meet a businessâs short-term obligations. Assessing working capital is an important financial tool for small business owners and can be done with a quick evaluation of business assets and operating expenses. Short-term working capital shortages can cause serious hardship for a small business owner but working capital loans can provide a smart business financing solution.
In this article, we discuss a checklist and calculation small business owners can use to measure their working capital. We also cover business financing options for those businesses that need to supplement working capital.
How to measure working capital
In short, working capital is determined by looking at the assets of a small business. Understanding the working capital needs of a business involves plotting month-by-month inflows and outflows. Examining current working capital can determine whether the business can sustain its financial position under current conditions or if it could benefit from a working capital loan. Working capital can be calculated using the working capital ratio or by creating a working capital checklist.
Working capital ratios
Calculating working capital ratios allows entrepreneurs and small business owners to get a more detailed view of their companyâs short-term financial position. There are two formulas used to calculate working capital: the current working capital ratio and the net working capital formula. Both calculations are based on a basic understanding of the businessâs assets and liabilities.
- Asset – Property that has monetary value. Assets appear on a company’s balance sheet and inventories of probate estates. They are classed as current or long-term based on liquidity. Current assets include cash, inventory, accounts receivable, and other assets that can be liquidated in the current 12 months. Fixed assets include land, buildings, equipment, and other capital expenditures and intangible assets include patents, business goodwill, and other marketing rights.
- Liability â Liabilities include everything a business owes, like accounts payable, mortgages, payroll, and other financial obligations. Current liabilities are debts that the business will pay on in the current year and long-term assets describe notes payable balances and other debts that are due after the period of 12 months.
Working capital ratio
The formula to measure working capital is:
Working capital = Current assets Ã· Current liabilities
When the assets and liabilities of a small business are used to calculate the working capital, the result is a number that indicates the financial health of the organization. According to industry standards, a balanced, or healthy, working capital ratio is between 1.2 and 1.8. A ratio less than 1.0 is interpreted as negative working capital and indicates that the business may not be able to cover its current liabilities. On the other hand, a ratio greater than 2.0 may mean that the business is not efficiently using available funds.
Net working capital formula
Net working capital is a second calculation of the working capital ratio to determine the amount of money a small business has on hand to meet current liabilities.
Net working capital = Current assets â Current liabilities
This formula results in a dollar amount equal to the amount of money readily available for short-term operational expenses. If the amount is negative, it indicates that the business does not have enough cash to meet current obligations.
Working capital checklist
The working capital ratio is a helpful financial tool to quickly assess cash flow, but it does not give a complete picture of the small businessâs health. Using a working capital checklist can help a business have a more thorough understanding of its current assets and liabilities used to calculate the working capital ratio.
Reviewing the following parts of your small businessâs current assets will indicate the strength of the current working capital and whether or not a working capital financing is a practical solution.
- Cash position â Take note of cash held onsite and in the business checking account or savings accounts.
- Liquid investments â Review short-term investments like money markets and CDs that mature within the next 12 months.
- Prepaid expenses â Prepaid expenses reduce long-term operational costs and often result in discounts but impact the current cash position of the company. Reevaluate the business policy for prepaid business expenses, like insurance and lease payments, regularly.
- Accounts receivableÂ (AR) â AR describes the money owed to your small business. To maintain a healthy AR balance, be sure to send invoices on time, follow up with customers, and resolve billing disputes promptly.
- Inventory â Inventory management is an important part of any organizationâs operations and should be tracked diligently and compared with sales to find discrepancies quickly. Ideally, a small business should have an equal balance between the on-hand inventory and sales.
A companyâs liabilities determine how much money is owed to employees, vendors, government agencies, and banks.
- Accounts payable â Good business practice suggests avoiding late payments to vendors and keeping detailed records of all financial transactions.
- Short-term debt â Business credit cards and lines of credit provide flexible short-term financing for businesses but be sure to take note of available credit when analyzing working capital.
How working capital loans benefit small businesses
If an in-depth evaluation of your small business indicates a potential shortage in working capital, a loan may be a smart financial decision. There are many reasons small businesses choose to take advantage of working capital loans including the following uses of capital.
Many small business plans begin with a strategic decision to grow a successful business, but a lack of funds is the number one reason businesses fail to grow. Working capital loans can help small business owners purchase inventory in bulk, launch a marketing campaign, or take advantage of an expansion opportunity. Smart decision-making and the ability to act quickly can be detrimental to the success of a small business, so it is imperative that the necessary cash flow is available when needed.
Cash flow fluctuations
Some businesses experience seasonal changes in revenues, like toy retailers bringing in high revenues during the holiday season or paving companies experiencing low sales during freezing temperatures. Business working capital loans can provide small business owners with the financing they need to cover operations when income is lower. Short-term loans can then be repaid when annual revenues are higher.
New businesses need equipment, office space, computer software, inventory, staff, and several other business tools or supplies to get started. No matter how promising a business model is, it takes time to start making money. Working capital loans provide entrepreneurs and startup business owners with the financing needed to get their operations on the path to success.
Unexpected expenses occur. While they are unavoidable, covering the costs of broken equipment, replacing inventory, or repairing storm damage can quickly deplete the cash reserve. While some unexpected costs, like theft or disaster, are reimbursable through insurance, those claims can take an extended period of time to be completed.
Types of working capital loans
Working capital loans describe any type of small business loan that provides smaller amounts of capital quickly. Loans that are in response to business needs involving a large purchase or unforeseen expense are often categorized as working capital loans.
Invoice factoring is not technically a loan, but a creative financing option that lets small business owners receive cash immediately for invoices. It works when the borrower sells all or some of its unpaid invoices to a factoring agent at a discount. The invoice factoring agent then collects the invoices and sends the balance to the business, minus the fees which are calculated at a set factor rate.
Note: Invoice factoring is not the same as Invoice financing, a similar funding option where a business takes out a line of credit using unpaid invoices as collateral.
A business short-term loan is a traditional type of financing where the borrower receives a lump sum payment upfront and is obligated to pay the funds back with regular monthly payments, according to the repayment terms presented to the borrower at the loan closing. The interest rate for term loans can be fixed, where it remains constant throughout the life of the loan, or variable, where the market determines the rate. Term loans can be secured, where an asset is used as collateral or a personal guarantee is required, or unsecured, where the borrowerâs creditworthiness secures the loan.
Merchant cash advances
A merchant cash advance (MCA) is a way for small businesses that collect revenues through credit card payments to receive an advance on future sales. The borrower repays the advance, or loan, with weekly or monthly, payments based on an agreed-upon percentage of sales. MCAs are a great financial tool for borrowers that have bad credit or no business credit history that expect revenues to increase with time.
The U.S. Small Business Administration, or SBA, guarantees a portion of SBA loans for approved borrowers. SBA loans offer lower down payments and lower interest rates than traditional sources of funding and are designed to help small businesses grow. SBA loans are approved for any loan amount up to $5 million and can be used for working capital, commercial real estate purchases, renovations, and debt refinancing. There are many different SBA loan programs including, SBA 7(a) loans, Microloans, and disaster loans, each of which has different regulations regarding the use of funds and the repayment terms. While a good credit score makes SBA loan approval more likely, there are programs for all credit scores.
Working capital line of credit
A business line of credit is a type of revolving credit that can be thought of as a cross between a loan and a business credit card. A line of credit does not provide the borrower with a lump sum payment like a traditional loan but allows them to withdraw funds as needed. Interest is charged only on the amount of credit the small business has withdrawn. Working capital lines of credit are a great way for new business owners to build credit history which leads to more financing options in the future.
Where to get a working capital loan
A working capital loan is a powerful financial tool to ensure that your small business has the cash flow needed to support business growth and finding the best place to get a small business loan is easier than most borrowers expect. Small businesses can work with traditional lenders, like banks and credit unions, for some traditional loan options or alternative lenders, like Biz2Credit, for several different small business funding options.
Alternative, or online, lenders are often preferred by borrowers over traditional bank loans for working capital needs because they work with different financial institutions and can offer multiple loan options. Business owners that are looking for fast financing also turn to online lenders for an easy application process and loans that are funded to their bank account in as little as 2-3 business days.
Working capital is the amount of money a business has to cover operational costs, so any shortages require a quick response from business owners. Working capital loans are a great way for small businesses to fund growth, cover seasonal fluctuations, and pay for startup costs or unexpected large expenses. Working with an online lender is a great way to get fast access to working capital, like a North East manufacturing entrepreneur who was able to get a $300,000 working capital line of credit just 15 days after contacting a financing expert at Biz2Credit.