What Is Working Capital?
The term “working capital” refers to all assets currently available for covering monthly business expenses or operational costs. Working capital typically covers payroll, rent, supplies, vendor bills, debt payments, and other day-to-day expenses. Besides keeping your business up and running, working capital funds growth-related initiatives, like hiring more workers or acquiring more customers.
Why Do Businesses Need to Calculate Net Working Capital?
Net working capital doesn’t just reflect the value of your assets and cash. It also represents your business’s overall financial health and ability to capitalize on opportunities. More working capital increases your business’s capacity for growth and chances for survival in the event of an emergency. You can even think of working capital as your business’s life counter. The less working capital your business has, the shorter its projected lifespan becomes. It’s no wonder insufficient working capital ranks among the most common reasons for business failure.
However, continuing to apply the net working capital formula greatly decreases the chances of losing control of your finances.
What Is the Net Working Capital Formula?
To calculate your business’s net working capital, subtract your current liabilities from your current assets. The numbers that make up both parts of the equation should appear on your most recent balance sheet.
Current Assets = What your business owns (Cash, Inventory, Accounts Receivable, etc.)
Current Liabilities = What your business owes (Bills, Payroll, Loans, Accounts Payable, etc.)
Net Working Capital = Current Assets – Current Liabilities
Your current assets must exceed your current liabilities to meet short-term obligations. This, if you intend to grow your business, you should look to increase the gap between what your business owns and what your business owes.
Net Working Capital Formula Example
To better illustrate how to calculate net working capital, we’ll use an example featuring hypothetical assets and liabilities. This particular scenario uses yearly numbers to determine the sample business’s finances at the end of the year. Many financially conscious businesses, however, calculate net working capital every month or every quarter.
Current Assets Available For Coming Year
- Cash on hand: $300,000
- Accounts receivables: $500,000
- Inventory: $800,000
Total current assets = $4.3 million
Current Liabilities Owed For Coming Year
- Accounts payable: $400,000
- Short-term debt payments: $50,000
- Portion of long-term debt due this year: $50,000
- Operational Expenses: $600,000
Total current liabilities = $1.1 million
Net Working Capital = Current Assets – Current Liabilities
$4.3 million – $1.1 million = $3.2 million
By calculating net working capital, we can see that the sample business will have approximately $3.2 million left over after paying all liabilities for the year. With all expenses out of the way, some of this leftover money can go in the bank, with the other portion going towards growth-related initiatives.
How Do You Find Your Working Capital Ratio?
The net working capital formula will produce an amount in dollars. Sometimes, though, looking at this number won’t immediately tell you if you have healthy working capital. Due to individual factors like industry or company size, which seems like healthy working capital for one business could represent the bare minimum for another.
The answer to your working capital ratio, on the other hand, leaves no room for uncertainty. While the net working capital formula subtracts assets from liabilities, the working capital ratio formula divides them.
Current Assets / Current Liabilities = Working Capital Ratio
If your working capital ratio ranges between 1.2 and 2.0, you have healthy working capital, regardless of the aforementioned factors. Anything higher than 2.0, however, might suggest insufficient spending or too much unused working capital. Maybe you’ve neglected to invest enough profits back into the business or failed to spend enough money to generate growth.
What Counts As Current Assets and Liabilities?
It’s only natural to find the terms “assets” and “liabilities” confusing. Different business owners and finance professionals tend to have different definitions for each term. We’re going to use the most generally accepted definition in this guide.
Let’s start with assets.
According to the general definition, current or “liquid” assets refers to cash and anything that you can convert to cash within the maximum span of one year. Examples include inventory, outstanding accounts receivable, or stock the business holds in another company. This differs from long-term assets, which refers to assets that you cannot easily convert into cash within one year. This can include real estate, equipment, copyrights, etc.
Now for liabilities.
Current liabilities refer to all loans or expenses you owe within the maximum span of one year or the company’s standard operating cycle. Examples include short-term business loans, accounts payable, and accrued expenses like taxes and wages.
Understanding the difference between current assets and long-term assets can prevent you from having too much money tied up in the latter variation. This would significantly decrease your working capital. It would be best if you instead strived for an equal balance between the two.
Is Negative Working Capital Always Bad?
Most businesses cannot succeed with negative working capital or when their current liabilities exceed their current assets. In some industries, however, negative working capital does not necessarily signify poor cash flow. These businesses do not need large amounts of working capital to sustain operations continuously.
Many fast-food chains, for example, never go one day without making multiple sales. They always have cash flowing in but must constantly spend it to serve their customers, rather than saving it up. This often results in negative working capital.
Businesses that can succeed with negative working capital also don’t need to expand to survive. Negative working capital prevents you from growing anytime soon. Like grocery stores, certain businesses will do just fine without increasing staff, marketing, or other resources.
Lastly, the incredibly high inventory turnover rates of fast food chains and grocery stores technically offset their negative working capital. This means they have more cash than unsold inventory typically, and the value of the former greatly outweighs the latter.
How To Build More Working Capital for Business:
Profitability, cash flow, and working capital tend to get lumped together. This makes sense because improving one of these things almost automatically improves the two others. The best practices for improving profitability, for example, will usually improve cash flow and working capital.
In other words, you don’t really have to think “outside the box” when developing strategies for improving your net working capital. Rather than focusing exclusively on working capital, you might want to focus on the most effective strategies for improving your finances in general. Anything that helps you save money or make more money will likely lead to more working capital.
Let’s reiterate those best practices here:
1. Decrease Spending
No strategy will increase working capital more quickly than freeing up as much cash as possible. When reviewing your financial statements, think about which expenses you can cut or reduce. After going over smaller expenses (memberships, software tools, travel, etc.), you can move on to bigger expenses like labor and the cost of goods sold.
You may conclude that employee salaries make up your biggest expense, by far. If so, consider doing more with fewer people. For example, instead of hiring new employees to perform additional tasks, you might want to train current employees to handle them. You’d have to pay them more money, but nowhere near as much as you’d have to pay new employees.
As for the cost of goods sold, you may have earned the right to ask suppliers for better rates or discounts on certain orders. Do you always pay on time? Do you regularly order from this supplier? Customers with long track records of orders and timely payments shouldn’t worry about overstepping their boundaries by asking for occasional discounts.
2. Decrease Late Payments
Decreasing your accounts receivable cycle makes each sale more profitable and therefore increases working capital. You could accomplish this by sending more than one invoice per month with an automated invoicing system. Other strategies include offering discounts to customers who pay early or only offering 30-day terms to new customers or existing customers with flawless payment histories.
3. Don’t Order Too Much Inventory
The longer an item sits on your shelves, the less profitable it becomes. Therefore, most retail-oriented businesses should only order enough inventory to satisfy the current demand level. Popular tactics for this objective include better forecasting of demand or using a business line of credit to practice “last minute” inventory management. The latter option would give you extra cash to place orders despite slower revenue or less operational funding at your disposal.
4. Lower Monthly Debt Payments
Spending too much money on monthly debt payments takes away working capital. The debts costing you the most money likely have the highest interest rates. For that reason, you should focus on eliminating these debts as quickly as possible.
Instead of continuing to make minimum payments, see if you can afford to pay more each month. Once you’ve paid off that debt, apply the same principle to the debt with the next highest interest rate, and so on.
How Does Net Working Capital Affect Access To Business Loans?
Many financial institutions prioritize working capital when deciding whether to approve or reject an application. The more working capital you have on hand, the higher the likelihood of being approved for high amounts, convenient terms, and low interest rates.
For example, banks offer the cheapest business loans on the market because they usually work with heavily capitalized businesses. These borrowers tend to have so much working capital saved up that they don’t actually need the bank’s money. If the business went under or the investment turned sour, the business would still have no trouble paying off the loan.
Companies like United Capital Source, on the other hand, frequently work with younger, under-capitalized businesses. After all, businesses need more working capital to grow. The right type of business loan could supply that extra capital and eventually generate more revenue, profits, and, you guessed it, working capital.
What Are the Best Business Loans for Extra Working Capital?
Several types of business loans contain repayment structures geared towards short-term investments. This makes them ideal for businesses in need of extra working capital instead of much larger sums of cash. You could use the funds to finance day-to-day operations, pay off existing debts, hire more workers, or take advantage of sudden opportunities. These functions have low to moderate costs, so smaller businesses won’t struggle to pay off the debt. Business loans geared towards long-term investments, on the other hand, tend to have higher borrowing amounts and longer terms. Companies interested in these loans have plenty of working capital and will most likely use the money for game-changing initiatives.
The following business loans fulfill the former criteria:
- Short-Term Business Loans: Like the standard, traditional business loan, only with shorter terms ranging from 3-18 months.
- Working Capital Loan: This borrowing amount for this loan directly reflects the monthly costs of running your business. The terms and repayment structure usually resemble those of short-term business loans.
- Business Line of Credit: You can borrow from your credit line at any time, and you only make payments when you borrow.
- Merchant Cash Advance: You receive a lump sum paid back via a fixed percentage of daily debit and credit card sales.
- Revenue Based Business Loan (Business Cash Advance): Similar to MCA, but your payments are deducted via a fixed percentage of your entire monthly revenue.
- Invoice/Accounts Receivable Factoring: The financial institution purchases your outstanding invoice/receivable for a discount price and pays you right away.
Where Can Businesses Find the Best Working Capital Loans?
The following institutions carry at least one of the products listed above. They have looser requirements for approval due to the products’ shortened terms and higher rates. This includes the applicant’s working capital situation. While banks might ask for years’ worth of financial information, these institutions typically only require three months’ worth of bank statements. They need to see that your business has healthy cash flow at this specific moment. Having so little paperwork to go over allows the institutions to approve and distribute funding in just 24-48 hours.
Ondeck offers short-term business loans and lines of credit. For short-term business loans, borrowers must have a personal credit score of 500+, 1+ years in business, and $100,000+ in annual revenue. For business lines of credit, borrowers must have a personal credit score of 600+, 1+ years in business, and $100,000+ in annual revenue. Most borrowers reportedly have scores of 660 or higher.
You can borrow up to $500,000 for short-term business loans compared to $100,000 for business lines of credit. Payments for short-term business loans must be made daily or weekly.
BlueVine offers business lines of credit and invoice/accounts receivable factoring. For a 6-month business line of credit, borrowers must have a personal credit score of 600+, 6+ months in business, and $120,000+ annual revenue, 12-month line of credit: 620+ personal credit score, 2+ years in business, $450,000+ annual revenue.
You can borrow up to $2,000 – $250,000 for each LOC. Invoice/Accounts Receivable Factoring: 530+ personal credit score, 3+ months in business, $100,000+ annual revenue. You can borrow $20,000 – $5 million.
3. Credibility Capital
For a short-term business loan, borrowers must have a 680+ personal credit score, 2+ years in business, and $250,000+ in annual revenue. You can borrow up to $250,000.
For a short-term business loan and business line of credit, borrowers must have a 600+ personal credit score, 1+ year in business, and $75,000+ annual revenue. You can borrow up to $250,000 for both. For invoice/ accounts receivable factoring, borrowers must have 540+ personal credit scores and 1+ years in business, with no annual revenue requirement. You can borrow up to 90% of invoices and 80% to 90% of government contracts.
5. United Capital Source
For all five lenders listed above, borrowers must be in business for at least six months and earn $100,000 in annual revenue. Borrowers with low credit scores (around 500) can be approved for short-term business loans, merchant cash advances, and revenue based business loans.
You can borrow up to $250,000 for a business line of credit, $1M for a merchant cash advance, $10,000 – $5M for a working capital loan and business cash advance, and $10,000 – $10M for invoice/accounts receivable factoring.
Here is the paperwork required for most of these products:
- Driver’s License
- Voided Business Check
- Bank Statements
- Credit Score
- Business Tax Returns
- Credit Card Processing Statements
- Proof of Ownership
Improving Net Working Capital: Recap
Working capital doesn’t just represent your business’s liquidity. If you have healthy working capital or positive working capital, it shows firm control over your business’s most important elements. If one of those elements begins to slip, your working capital will likely do the same. So, as long as you keep an eye on cash flow, profitability, expenses, revenue, etc., you won’t have to worry about working capital problems going unnoticed. And if one such problem does arise, the solution will appear right alongside it.
How have you increased working capital in your business? Please share any thoughts or resources on our contact page!