Working capital consists of funds to keep your business up and running, pay employees, pay vendors, for rent and other expenses. It’s generally not for investments or reaching long-term goals. 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 high profit potential.
What is working capital?
Working capital impacts many areas of your business, from paying your employees and suppliers to keeping the utilities on and planning for sustainable long-term growth. In short, working capital is the money available to meet your current, short-term obligations.
To make sure your working capital works for you, you’ll need to calculate your current levels, project your future needs and consider ways to make sure you always have enough cash.
Examples of working capital calculations
Calculate the working capital ratio for your business. This ratio is a measurement of your company’s short-term financial health.
The working capital ratio formula:
- Current assets / Current liabilities = Working capital ratio
If you have current assets of $1 million and current liabilities of $500,000, your working capital ratio is 2:1. The optimal ratio is to have between 1.2 – 2 times the amount of current assets to current liabilities. Anything higher could indicate that a company isn't making the best use of its current assets.
The net working capital formula:
- Current assets – Current liabilities = Net working capital
Consider only short-term assets such as the cash in your business account and your accounts receivable —money owed by your customers — and the inventory you expect to convert to cash within 12 months.
Short-term liabilities include accounts payable — money you owe vendors and other creditors — as well as other debts and expenses for salary, taxes and other business obligations.
Finding the best working capital for your business
There are several avenues to explore when you need working capital. You should strive to get the lowest costing funds with the longest terms to ensure low payments.
Traditional Bank Loans
Proceeds from a bank term loan can be used for working capital to help meet your business goals. An additional benefit? Paying off a bank term loan responsibly helps to build business credit. SmartBiz currently offers term loans through its bank partners for working capital, debt refinance and new equipment purchase:
- $30,000 to $250,000 loan amounts
- 2 – 5 year repayment terms
- Fixed interest rate*
- Monthly repayments
- No pre-payment penalties
*Interest rate depends on loan term and the applicant's credit and financial profile.
Learn more here about Bank Term loans available through the SmartBiz bank network: Bank Term Loans.
The 7(a) Loan Program is the Small Business Administration’s primary program for helping small businesses with financing. The SBA does not actually make direct loans; instead, it provides loan guarantees, promising the bank to pay back a certain percentage of your loan if you are unable to.
Frequently seen as the “gold standard” in small business loans, an SBA loan might have the longest-terms and lowest-interest available in the marketplace. SBA lenders look for applicants with good credit, a solid business plan, collateral, and a demonstrated ability to repay the loan.
Learn more about SBA loans, requirements, and application details on the SmartBiz Loans website: SBA 7(a) Loans.
Lines of Credit
Another type of small business financing available from banks and other lenders is a line of credit. Similar to a credit card, business owners can take out funds on an as-needed basis. Credit lines often have shorter repayment terms and are best for short-term working capital needs. The costs involved in establishing a credit line are one of the drawbacks. Up-front fees are required to establish the line and a business must pay interest on the money it uses from the line of credit. Learn more here: Line of Credit for Small Business: Pros and Cons.
Small business credit cards provide your business with a number of advantages. They make it easier to separate your personal and business expenses. Small business cards usually offer a higher credit limit than any personal consumer cards. They give you the ability to manage cash flow, as in most cases you’ll have 20 to 30 days to pay off any business expenses without interest.
Small business credit cards allow you earn rewards like points or cash back on most business expenses.
Depending on your card, they’ll come with perks such as travel credits, elite member statuses for airlines and hotels, and free night stays. They’ll provide benefits on merchandise discounts, purchase protections, warranties, and travel insurance. Most cards provide protection against any theft and damage. Here’s an article with more details so you can make an informed decision: Finding the Right Credit Card for Your Small Business.
Crowdfunding is the use of small amounts of capital from a large number of individuals to finance a new business venture. Crowdfunding makes use of the easy accessibility of vast networks of friends, family and colleagues through social media websites like Facebook, Twitter and LinkedIn to get the word out about a new business and attract investors. Crowdfunding has the potential to increase entrepreneurship by expanding the pool of investors from whom funds can be raised beyond the traditional circle of owners, relatives and venture capitalists. However, there are big drawbacks to going this route for working capital. Review this article on the SmartBiz blog: Reasons to Avoid Small Business Crowdfunding.
When a business owner uses equity financing, they are selling part of their ownership interest in their business. This can be a complex strategy so working with an attorney is recommended.
Trade credit is an important external source of working capital financing. It is a short-term credit extended by goods and services suppliers in the normal course of business, to a buyer in order to enhance sales.
Why businesses need working capital
To increase profits
“Increasing profits” may sound like an unreachable goal for a hard-working business owner. But there are solid strategies you can put in place to up your sales. Learn strategies to attract new customers and sell more to your existing customer base in a post from the SmartBiz Small Business Blog: 10 Tips and Tricks To Increase Sales For Your Small Business.
Equipment upgrades, repairs, or replacements
When you’re ready to buy, repair, or replace large, tangible assets like trucks and machinery, you might need additional capital to finance the purchase. A working capital loan can cover everything from medical tools to computers to restaurant ovens, depending on your industry. You’ll be able to increase productivity, maximize efficiency, and bring in more sales with up-to-date equipment.
Marketing can include everything from social media promotion to attending industry trade shows. Other marketing costs that can be covered by a working capital loan include:
- Agency fees
- Customer surveys
- Development of advertising and other promotions
- Gifts to customers
- Online advertising
- Printed materials and displays
- Social media monitoring and participation
Putting profits into your marketing department is an example of an investment that provides a potential long-term payback through increased sales.
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.
Redirecting money back into your company is a positive step towards short-term growth. Be sure to leave some room for regular expenditures when deciding how much working capital to reinvest. Reinvesting in your business can include saving for equipment, increasing marketing, and more. A working capital loan can cover your regular expenses and help you invest in growth activities that will help you meet your long-term goals.
How to manage working capital
1. Manage inventory
Excessive inventory can put stress on your cash resources. On the other hand, an insufficient amount of products can result in lost sales and damage to your business reputation. This article has additional information if you’re having inventory management issues: Inventory Management for Small Business Explained.
2. Pay vendors on time
Companies that pay on time generally have better relationships with their suppliers and are in a stronger position to negotiate better deals, payment terms, and discounts. If you keep your suppliers happy, it could save you money in the long run when it comes to getting larger financial breaks for bulk buying and recurring orders. Additionally, paying on time to vendors who report to credit agencies can help build your business credit scores.
3. Manage expenses closely
When you set up an organized system to track business expenses, it will be easier to manage working capital. Additionally, you’ll simplify tax time. Can you quickly get your hands on your small business expenses? Some small business owners still use the “shoebox accounting” method of throwing everything into a drawer and sorting it out later. In today’s high-tech world, there’s no excuse for that chaotic method. Review these steps to help put an effective expense tracking system in place: How to Keep Track of Business Expenses.