What is working capital?
Working capital, also known as net working capital (NWC), is defined as the difference between current assets and current liabilities.
Current assets, according to the Small Business Administration’s website, are the most liquid of your assets. If you have money in a company checking or savings account, the cash is considered liquid because it can be withdrawn easily to settle liabilities. Investopedia® lists examples of cash and cash equivalents. In addition to bank accounts, marketable securities, and Treasury Bills are liquid. An example of a non-liquid asset is a real estate investment because it can take months to receive cash from the sale.
Current liabilities are any obligations due within one year. Working capital measures what is leftover once you subtract your current liabilities from your current assets. This can be a positive or negative number. Working capital represents the cushion of protection you can give your short-term creditors.
How is working capital calculated?
Here’s how to calculate your working capital:
Working capital = current assets – current liabilities
Working capital can be calculated using your balance sheet. A balance sheet, as described by the SBA, is a statement of a business’s assets, liabilities, and owner’s equity as of any given date.
A balance sheet is typically prepared at the end of set periods, such as every quarter or every year, and it consists of two columns. The column on the left lists the assets of the company. The column on the right lists the liabilities and the owners’ equity. Learn more about how to create a balance sheet on the SmartBiz Small Business Blog: How to Create a Balance Sheet for Business.
Positive vs. negative working capital
It’s important to know if you have enough capital or if your business is lacking.
A business has positive working capital if it has enough cash, accounts receivable, and other liquid assets to cover its short-term obligations, such as accounts payable and short-term debt.
A business has negative working capital if it doesn’t have enough current assets to cover its short-term financial obligations. If you have negative working capital, you may have trouble making payroll, paying suppliers and creditors, and raising funds to fuel growth.
Inadequate access to working capital and other financing options is one of the main causes of business failure in America. Of course there are many other factors that can sink a business. But without working capital, you’re simply unable to operate effectively.
Why is working capital important?
It’s critical to have positive working capital so you can fund operations and meet short-term obligations. If a company has enough working capital, it can continue to pay its employees, suppliers, interest payments, and taxes.
Working capital can also help smooth out fluctuations in revenue. Seasonal businesses, when sales are up or down depending on the time of year, can stock up on inventory to prepare for the busy months. Working capital helps you through the not-so-busy months when revenue is down.
How can you use working capital?
Working capital can be used in a variety of ways. Examples include purchasing inventory, launching marketing initiatives, hiring employees, paying taxes and unexpected expenses.
Avoid these working capital missteps
Make sure you review these issues before taking out a working capital loan. It’s always a good idea to revisit your business plan to help you determine the best approach to your finances.
- Improper use
Don’t confuse short-term working capital needs and longer-term, permanent requirements
- Poor financing decisions
While it can be tempting to use a working capital line of credit to purchase machinery or real estate or for hiring, these expenditures call for different kinds of financing. If you tie up your working capital on expenses like these, it won’t be available for its intended purpose
Where can you find working capital?
Working capital loans are available from online lenders, banks, and credit unions. Additionally, some companies who service small businesses, like PayPal® and Amazon®, are entering the lending space.
- Business credit cards
Business cards have a set credit limit and allow you to make purchases and withdraw cash. Like a consumer credit card, a small business credit card carries an interest charge if the balance is not repaid in full each billing cycle. Here’s some more information about this popular funding option: 5 Business Credit Card Myths.
- Invoice financing/factoring
Invoice factoring is not a loan in the traditional sense. Instead, you sell your customer invoices to a factoring company. They take care of collecting the payments, in exchange for a fee, which means you can receive funds more quickly.
Invoice financing is slightly different. You maintain control of your invoices, because instead of selling them to a factoring company, you use them as collateral when applying for a short-term cash advance.
- Line of credit
A business line of credit is a revolving line you can draw against as you need it, meaning that you only pay for the money that you use. Lines of credit can be extended by a large traditional bank, a small local bank, or an alternative online lender. Lines of credit can be secured, unsecured, short-term, or long-term.
- Merchant cash advance
Merchant cash advance companies provide funds to your business in exchange for a percentage of the daily credit card income. A processor clears and settles the credit card payment, drawn from customers' debit and credit-card purchases on a daily basis, until the obligation has been met. Most providers form partnerships with payment processors and then take a fixed or variable percentage of future credit card sales.
- Bank Term loans
Many banks offer term loans with a wide use of proceeds, including working capital. A Bank Term loan from lenders in the SmartBiz network is a short-term, fixed-rate loan with stable monthly payments. These loans are a great fit when you need funds quickly and want to lock in your interest rate. Another benefit? Paying off this type of loan responsibly helps to build business credit.
- Small Business Administration (SBA) 7(a) loan
SBA 7(a) loans have great rates, long repayment terms, and low monthly payments. These are government-guaranteed small business loans. The SBA provides a guarantee on the loan, promising to reimburse the bank for a certain percentage of your loan if you default on that loan. This guarantee lowers the risks to banks and other lenders, encouraging them to offer these loans to more American small businesses. Many banks and other financial institutions offer SBA loans, but their process, requirements, and fees can vary.
SmartBiz has streamlined the application process for an SBA loan from a bank in the SmartBiz network. In addition to an easy-to-navigate online platform, we're very clear about the documents needed. If you have your paperwork in order, the process can move swiftly from prequaliﬁcation to funding. We match borrowers with the bank that is most likely to approve and fund an SBA loan for your business. You won't waste time going from bank to bank, we help do that for you.
Visit SmartBiz today and discover if you’re qualified for an SBA loan.*
It’s a good idea to work with your accountant or another financial professional to determine when you need to get a loan, how much to borrow, and the best use of the funds. It’s impossible to predict every challenge your business will face. However, a clear understanding of working capital can help you operate smoothly and set you up for success.