Importance of Working Capital for Small Businesses
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Working capital is the liquid money you need to fulfill your business operations and meet short-term financial obligations like paying your employees and suppliers and making interest and tax payments.
It’s an essential form of capital to consider and work on improving if you want your business to succeed.
This blog post will discuss the advantages of working capital for small business owners, how to calculate your working capital, and how much capital you need.
5 Advantages of Working Capital for Small Business Owners
Cover Day-To-Day Expenses
If you have a rented office, employees working for you, inventories that need filling, unpaid debt, and insufficient working capital, it’s a sour recipe that can put an end to your business dreams.
Hence, keeping a close eye on your working capital and keeping it sufficiently fed is always a good idea. Having the right amount of working capital will help ensure your business continues smoothly and avoid the doom that 50% of small businesses face in their first five years.
Imagine a small printing company. There arises an opportunity for them to purchase raw materials inventory at a lower cost than usual. But, due to weak working capital, they couldn’t utilize this opportunity.
If it had the capital, it could enjoy the flexibility to seize the opportunity and increase its profit. To ensure you don’t end up squandering such changes, you must work towards generating sufficient working capital.
Did you start your small business with a dream to scale up and turn big one day? The road to this achievement isn’t easy, but investing in the right marketing strategy, hiring the right talent, and purchasing the right equipment at the right time can make the journey easier.
And to do all of this, you guessed it right; you need not just sufficient but excess working capital. If you have it, you can put the money into the above-mentioned elements, boost your revenue, and expand your operations.
Lenders love companies with sufficient working capital and, thus, are more inclined to extend loans with favorable terms. So, if you work on improving your liquid capital, then you’ll be more creditworthy and, as a result, attain credit on favorable terms. With the right amount of working capital, your suppliers will also be more willing to offer discounts and better payment terms to you.
Help You Weather Lower Sales
Small businesses that can boast consistently high sales throughout the years are rare to nonexistent. There may be months that account for most of your sales, while the demand for your service or product dangles low the rest of the time. But you have to cover your business expenses all year long.
Having enough working capital can help you weather these periods of low returns.
Consider a retailer that experiences an increase in demand during the summer months. The business generates 60% of its annual revenue during this period but still has to cover its expenses throughout the year, such as rent, utilities, and salaries.
By figuring out how much working capital it needs and keeping a good buffer, the business can ensure it has enough funds to stock up on supplies before the summer rolls.
Additionally, the business can hire temporary staff to handle the increase in demand while planning how many permanent staff it can support during the rest of the year. This way, the retailer (and you) can meet the seasonal demand while ensuring it has enough working capital to cover its expenses throughout the year.
How to Calculate Your Working Capital?
Now that you are clear about the advantages of working capital, it’s time to calculate yours and figure out if you have enough.
The basic formula for calculating working capital is:
Working Capital = Current Assets – Current Liabilities
You have enough money to pay short-term expenses and debts if the number is positive. If the number is negative, you are having trouble making ends meet.
You can also find out your working capital ratio by dividing your current assets by current liabilities. The ratio is helpful to give you a quick idea of your company’s financial health.
Generally, the higher the ratio, the better an indicator of a company’s ability to pay short-term liabilities.
How Much Working Capital Should You Have?
For small businesses, the general rule is to always strive for positive working capital.
However, apart from keeping the capital positive, you also need to consider how much working capital you need. That depends on several factors, like the type of business, your goals for future growth, and your operating cycle.
For example, if your business relies on physical inventory, you’ll need considerable working capital to run smoothly. However, if your company provides intangible products or services, like online software, generally, you will only require a little working capital.
But, if you provide intangible products or services and want to scale up your business, you should strive for more working capital to put extra into avenues like marketing and R&D.
The operating cycle also plays a huge role in determining your working capital. Companies that take a long time to create and sell a product need more working capital than companies with shorter production cycles. Also, companies that work on the principle of accounts receivable need more working capital than companies that take payments before rendering their goods or services.
The bottom line is: to consider the three factors when deciding your working capital goal and always strive to keep the value positive.
However, if, for some reason, you need to generate more working capital but can’t find a way to do it on your own, there’s always an option to get working capital financing. With this option, you can cover your expenditure gap without keeping any collateral on the line.
For more insightful articles and actionable tips about finance and business, check out Capital for Business’ The Working Capital and Financing Blog.
Did you enjoy this article? Here’s more to read: Tips for Selecting the Best Equipment for Your Business
About The Author:
Lyle Solomon has extensive legal experience, in-depth knowledge, and experience in consumer finance and writing. He has been a member of the California State Bar since 2003. He graduated from the University of the Pacific’s McGeorge School of Law in Sacramento, California, in 1998 and currently works for the Oak View Law Group in California as a principal attorney.
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