One of the biggest needs small businesses have is the need to working capital. Working capital is the lifeblood of the business, the fuel that finances day-to-day operations and the ability to pursue short-term growth opportunities for the business. Working capital is officially defined as “….”. The financial equation to determine the working capital is as follows:
(Accounts receivable + inventory + cash on hand) – (Accounts payable + prepayments)
There are numerous sources of working capital for businesses. Looking at the equation, one way to get additional working capital is to increase accounts receivable (that is, sell more) or convert accounts receivable to cash by having customers pay earlier. Continuing to examine the equation, another way is to increase inventory. When examining the balance sheet of a business in order to acquire that business, it is important to examine how these parameters fluctuate as part of working capital. A business can increase inventory and accounts receivable significantly, dramatically increasing the amount of “working capital” denoted. However, those accounts receivable could be essentially uncollectible and the inventory could become obsolete. Either of these would essentially negate the benefits of a large “working capital.”
You can access cash by having customers prepay for their orders by offering significant discounts for doing so. For example, if a customer purchases a monthly service for $ 100, you can offer them a discounted prepaid annual rate of $ 1,000. That is roughly a 20% discount, but when the time value of money is taken into account, the discount falls between 5 and 8% (depending on its internal rate). If you sell much larger product or service contracts, the difference in actual cash can be profound with prepayments. On the other side of the equation, you can have your vendors extend deadlines. Instead of waiting for payment within 15-30 days, you may be able to delay 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 vendors, 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 necessary cash through financing that uses one or both of these two as collateral for loans.
Working capital for businesses is something that many small business owners don’t plan for. They often don’t think about it until they run into a cash crisis. Or sometimes, not until they’ve run into a series of cash problems and are tired of the stress of not knowing how they will make payroll or pay angry vendors.
Some of the countless sources of financing working capital for companies They include short-term asset-based lines of credit, term loans, equipment loans, signed lines of credit, supplier financing or extended repayment terms, economic development grants, and factoring. Generally, loans against accounts receivable and inventory are short-term lines of credit, renewable annually. Some banks and other financial institutions will extend a three- to five-year term loan with a high-grade collateral. (i.e., accounts receivable that are typically paid within 30-45 days and are with highly creditworthy customers and inventory that is replaced within a similar time frame).
The important thing is to always keep in mind what “working capital” is and what it implies. It is vitally important to keep track of your business cash and how quickly your business converts its short-term assets to 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 need to use it, but you should have it on hand to use in a crisis. I have had clients who have lost important clients to bankruptcy. That unfortunate scenario happened more often in 2010 and 2009 than in previous years, but it could happen at any time. If your clients have large accounts receivable due close to 90 days, their exposure to such a scenario is drastically high. Even if your risk is low, when a customer is unable or unwilling to pay accounts receivable in a timely manner, where will the cash come from to run the business while solving 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.