What is Working Capital?

If you’re a small business owner, you probably had an idea of what your business would be before you even began. All you’d have to do is sell something or provide a service, and the customers would come. If only it were that simple! Instead, you probably found yourself having to learn about a whole bunch of new concepts and processes as well. One of the terms you’ve probably heard getting batted around is “working capital.” What does that even mean, and how does it affect your business?

Here's What It Means

If you take your business’s current assets, and subtract your current liabilities, you’ll have a number that may be positive or negative – that’s your working capital. Another way of looking at it is to say that working capital is how much in liquid assets you have available for expansion and growth. Your assets could be everything from the amount of cash is in your business accounts, to any equipment or facilities you own free and clear, to long-term loans, to your inventory. All of that is worth money, and is considered an asset.

Your liabilities could include some of those same things as well. If you run a pet store, for instance, you might have live animals – which require food and care, making them a liability that costs you money the longer they sit in your store. If you have a mortgage for the store itself, that’s also a liability. Leased equipment, lines of credit, business credit card debt, and other obligations all come together to fill the liability section of your balance sheet and affect your working capital.

As a small business owner, you should be concerned about how much working capital you have because it can determine the strength of your business and the timeline for any expansion or growth you have planned. Without working capital you can’t meet the day-to-day financial needs of your operation, pay for any emergencies or unplanned expenses, or expand and grow your business – and if you can’t do those things, your business is unlikely to make it. In fact, the top reason for business failure in the first two years comes down to a lack of working capital.

The good news is that if you find yourself short on working capital, there are ways to raise it and keep your business flowing. A small business loan is one of the ways you can pay for the day-to-day operations of your business during a seasonal ramp-up, for instance, when you need to be high in productivity in preparation for a future sales run.

Small Business Working Capital Loans

A working capital loan will give you some flexibility by covering your daily operating expenses. A coffee shop owner, for example, may sell a great deal of coffee and cocoa in the winter, but sales drop in the summer. The summer growing season is when his coffee beans are least expensive, however, and he needs to purchase them then. He’d also like to expand his business to offer ice cream in the summers to help boost lagging warm-weather sales.

Taking out a working capital loan could solve several of the owner’s problems; he would have the money to purchase beans for the winter, and the loan could also purchase equipment to expand into selling ice cream seasonally as well. Since the loan is paying these expenses, the owner doesn’t need to dip into savings, and since the equipment and beans will only help increase sales, the loan can get paid back with no problems.

If you run a small business, you know how vital it is to always have enough cash on hand to pay your bills, respond to unforeseen problems, and take advantage of sudden opportunities. Whether it’s paying for an important marketing campaign, meeting your payroll obligations, or paying your vendors for goods and services, you need to have sufficient resources to do what is necessary to sustain and grow your business.

Cash, and other assets easily turned into cash, is part of working capital, defined as current assets minus current liabilities. A current account is one that is expected to be used or paid within a year. Current assets include cash, short-term notes, accounts receivable, and inventory. Current liabilities are made up of accounts payable, salaries payable, and rent payable, to name a few. The extent to which your current assets exceed your current liabilities is a measure of your business’s efficiency and short-term financial well-being.

Small Business Loans

One of the standard ways to shore up working capital is through a small business loan, which can immediately infuse cash into your company. Small business capital loans usually involve relatively modest amounts of money, often well under $1 million. Because these loans are small from a business perspective, they often carry less restrictive terms.

Small business loans can be uncollateralized, in which the lender is trusting in the borrower’s creditworthiness, or collateralized, where the lender can take possession of property pledged to offset the loan’s risk should it go unpaid.

At one time, banks were the originators of almost all small business loan volume. This changed in recent decades with the advent of alternative lenders, especially after the banking disaster of 2008. The internet features dozens of online commercial lenders as well as peer-to-peer lending portals that allow small businesses to shop around for the best terms available.

Alternatively, factors are willing to make loans collateralized by a company’s accounts payable or inventory. Some of the best terms are available on loans guaranteed by the Small Business Administration. The SBA will guarantee up to 80 percent of an eligible loan’s principal through a variety of financing programs.

Working Capital Loans

Working capital loans are geared towards stabilizing a company’s soundness in the face of challenging cash flows. They are meant to be short-term loans that help a company pay its bills. They are not meant for long-term projects such as construction of new stores or acquisition of expensive equipment – other types of loans are better suited for long-term needs.

A healthy company normally has a working capital ratio (current assets divided by current liabilities) between 1.2 and 2.0, although this varies by industry. A ratio below 1 indicates that liabilities exceed assets, a situation that can lead to loan payment delinquency and bankruptcy. A long-term decline in working capital signals a significant problem that must be addressed. It could mean that sales are declining, account receivables are going uncollected, the business’s expenses are too high, or other operational problems.

Inefficient operations might mean that too much money is tied up in inventory or accounts receivable. Although most of their value can be eventually converted to cash, these assets can’t be used directly to pay the company’s obligations. A working capital loan can tide over a business until the operational issues are settled. An affordable loan makes sense if you expect cash flows to improve, and you want to avoid fire-sale pricing of your inventory or selling off your invoices at a deep discount just to raise cash.

Potential Benefits

Working capital loans have several benefits:

Protect Your Own Money​

It might be tempting to use your personal money to supplement your business’s working capital, but borrowing makes more sense, especially when your business is a legally separate entity with limited liability. That’s because only the company’s assets can be attacked by creditors, while your home, car, and personal property are shielded.

Handle Financial Contingencies as They Arise

When your cash runs low you might delay payments to creditors, thereby lowering your credit score and making new credit costlier and/or harder to get. Bankruptcy looms if things get out of hand. A working capital loan can get you past the rough spots while preserving your creditworthiness.

Maintain Ownership

One alternative to borrowing is to take on partners, like equity investors, who will inject capital into your business. However, this means you’ll be forfeiting some of your decision-making power, and you’ll be receiving lots of suggestions you might not want. A loan lets you maintain 100 percent control of your company as long as you don’t default on the loan. In other words, a loan frees you from outside interference.

May Require No Collateral

If you get an unsecured business loan, you don’t need to pledge your assets to back up the loan, thereby increasing your flexibility to use those assets.

Convenience

Short-term working capital loans are usually quickly obtained and can be used as you see fit.

Potential Risks and Costs

Repayment

If you fail to repay on time, you risk default, a ruined credit rating, and bankruptcy. Remember, investors get paid after lenders during bankruptcy proceedings. You can end up with nothing.

Collateral May Be Required

If you don’t qualify for an unsecured loan, you’d have to pledge some assets as collateral. This puts these assets at risk, and you can’t dispose of them until the loan is repaid.

Interest Expenses

The riskier the enterprise, the higher the interest rates you’ll be charged. Paying interest, although tax-deductible, still drains money that could be used for other purposes.

Don't Address Long-Term Problems

The short payback periods of these loans means they are not meant to solve long-term problems like new construction, rehabilitation, expansion, and so forth.

Are Working Capital Loans Worth It?

Small business capital loans make sense if your company has a relatively good credit rating, but is undergoing a temporary rough patch. Many of these loans have favorable repayment terms, except if your credit history is bad or scant. Unless you have serious doubts that you’ll be able to repay on time, working capital loans make a lot of sense. They are easily applied for, quickly decided, and usually feature convenient terms. With so much competition among lenders, try using both online and brick-and-mortar loan brokers to get the best deal possible.

Read form the source here