One of the greatest needs that small businesses have is the need for working capital. Working capital is the lifeblood of the business, the fuel that funds the daily operations and ability to pursue near-term growth opportunities for the business. Working capital is officially defined as “….”. The financial equation for determining working capital is as follows:
(Account receivables + inventory + cash on hand) – (Account payables + prepaids)
There are numerous sources of working capital for businesses. Looking at the equation, one way to obtain additional working capital is to increase account receivables (i.e., sell more) or convert the receivables to 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 the working capital. A company can increase inventory and receivables significantly, drastically increasing the amount of “working capital” denoted. However, those receivables could be essentially non-collectible and the inventory could be obsolete. Either of these would essentially nullify the advantages of a large “working capital”.
You can access cash by getting customers to prepay their orders by offering significant discounts for doing so. For example, if a customer buys a monthly service for $100, you can offer them a yearly pre-paid, discounted rate of $1,000. That’s roughly 20% off but when you factor in the time value of money, the discount drops by 5-8% (depending on your internal rate). If you sell much larger service contracts or products, the difference in actual cash can be profound with prepaids. On the other side of the equation, you can get your supplier(s) to extend terms. Instead of payment expected within 15-30 days you may be able to push payment out to 90 days. You never know unless you ask.
From the perspective of the company owner, the larger the proportion of working capital in cash, the better. Cash can be spent on anything – to pay suppliers, pay employees, pay rent, pay for geographic expansion or product line development. Receivables and inventory not quickly converted to cash through turnover must be converted to necessary cash via financing that uses either or both of these two as the collateral for loans.
Working capital for business is something many small business owners do not plan. They often do not think about it until they encounter a cash crunch. Or sometimes, not until they have encountered a number of cash crunches and are tired of the stress of not knowing how they’ll make payroll or pay irate suppliers.
Some of the myriad sources of financing working capital for business include short term asset-based lines of credit, term loans, equipment loans, signature credit lines, supplier financing or extended payment terms, economic development grants, and factoring. Typically loans against receivables and inventory are short-term lines of credit, renewable annually. Some banks and other financing institutions will extend a term loan for three to five years against high grade collateral. (i.e., Accounts receivables that typically pay within 30-45 days and are with highly credit worthy customers and inventory that is replaced within a similar time frame.)
The important thing is to continually keep in mind what “working capital” is and what goes into it. It is vitally important to track your business cash and how quickly your company converts its short-term assets to cash. Not doing so can result in a significant shortage in working capital and, in short order, a liquidity crisis. If your company qualifies for a line of credit, get one. You don’t have to use it but you should have it on hand to use in case of a crisis. I have had clients who have lost major customers to bankruptcy. That unfortunate scenario occurred more often in 2010 and 2009 than in previous years but it could happen anytime. If your customers have large outstanding receivables that are close to 90 days, your exposure to such a scenario is drastically high. Even if your risk is low, when a customer cannot or will not pay receivables in a timely manner, where will your cash to run the business come from while you deal with the problem? Plan for the future and track your working capital. Your business will thank you for it in the form of stronger financial health.