One of the biggest needs that small businesses have is the need to working capital. Working capital is the lifeblood of the business, the fuel that finances daily operations and the ability to seek short-term growth opportunities for the business. Working capital is officially defined as “…”. The financial equation to determine working capital is as follows:
(Accounts receivable + inventory + cash on hand) – (Accounts payable + prepayment)
There are numerous sources of working capital for businesses. Looking at the equation, one way to get additional working capital is to increase receivables (ie sell more) or turn receivables into cash by getting customers to pay sooner. Continuing to examine the equation, another way is to increase inventory. When examining a company’s balance sheet for the purpose of acquiring that company, it is important to examine how these parameters fluctuate as part of working capital. A business can significantly increase inventory and accounts receivable by drastically increasing the stated amount of “working capital.” However, those receivables could be essentially uncollectible and the inventory could become obsolete. Any of these would essentially nullify the advantages of large “working capital”.
You can access cash by getting customers to prepay for their orders by offering significant discounts for doing so. For example, if a customer purchases a monthly service for $100, he may offer you a discounted annual prepaid rate of $1,000. That’s about a 20% discount, but when you factor in the time value of money, the discount falls to between 5 and 8% (depending on your internal rate). If you sell service contracts or much larger products, the difference in actual cash can be profound with prepaid. On the other side of the equation, you can have your provider(s) extend the time frames. Instead of expected payment within 15 to 30 days, you may be able to postpone payment to 90 days. You never know unless you ask.
From the perspective of the business owner, the higher the ratio of working capital to cash, the better. Cash can be spent on anything: paying suppliers, paying employees, paying rent, paying for geographic expansion or product line development. Accounts receivable and inventory that are not quickly converted to cash through turnover must be converted to needed cash through financing that uses one or both of these two as collateral for loans.
Working capital for businesses is something many small business owners don’t plan for. They often don’t think about it until they run into a cash crunch. Or sometimes not until they’ve faced a series of cash flow problems and are tired of the stress of not knowing how they’re going to pay payroll or pay angry vendors.
Some of the countless sources of funding working capital for companies They include short-term asset-based lines of credit, term loans, equipment loans, dedicated lines of credit, vendor financing or extended payment terms, economic development grants, and factoring. Accounts receivable and inventory loans are generally short-term lines of credit, renewable annually. Some banks and other financial institutions will extend a three to five year term loan against high grade collateral. (ie accounts receivable that are typically paid within 30 to 45 days and are with highly creditworthy customers and inventory that is replaced within a similar time period).
The important thing is to continually keep in mind what “working capital” is and what goes into it. It is vitally important to keep track of your company’s cash and how quickly your company turns its short-term assets into cash. Failure to do so can result in a significant shortage of working capital and, before long, a liquidity crisis. If your business qualifies for a line of credit, get one. You don’t have to use it, but you should keep it on hand for use in a crisis. I have had clients lose important clients through bankruptcy. That unfortunate scenario happened more often in 2010 and 2009 than in previous years, but it could happen at any time. If your customers have large outstanding accounts receivable that are close to 90 days old, your exposure to such a scenario is drastically high. Even if your risk is low, when a customer can’t or won’t pay receivables in a timely manner, where will your cash come from to run the business while you deal with the problem? Plan for the future and keep track of your working capital. Your business will thank you in the form of stronger financial health.