Working capital can have a big impact on the success of your small business. In fact, lack of access to cash is a big reason why many new SMEs fail. Understanding how working capital works, and how it impacts your business is important so that you can make the best financial decisions for your business as you grow.
What is working capital?
Working capital is a financial metric which can be used to indicate how financially healthy a business is. It is calculated by subtracting a company’s current liabilities from its current assets.
If a business has good working capital, it usually indicates it can easily fund its current operations and has cash left over to invest in future activities. An example of assets that contribute to working capital are:
- Cash reserves
- Unpaid invoices
- Raw materials
- Finished goods
- Property and equipment
An example of liabilities that impact working capital are:
- Payroll
- Utility bills
- Taxes
- Short-term loans
- Expenses
Why is working capital important?
Working capital is important for two reasons. First of all, high working capital usually means a business can fund its current operations even if it runs into cash flow challenges. Cash reserves, raw materials, accounts payable or finished goods all help SMEs ride out lulls or seasonal dips in sales without putting too much pressure on the viability of the business. Small businesses will usually find it easier to weather the storms of a downturn if they have high working capital to safeguard them through these times.
Businesses with low working capital may find it hard to finance day-to-day operations or meet liabilities during a dip.
High working capital isn’t just helpful in a downturn. Rapid business growth can be unsustainable. Working capital makes it easier for owners to qualify for loans and avoid investing personal savings into the business.
How much working capital does an SME need?
The amount of working capital a business needs depends on the industry it is operating in, its operating cycle, and its goals. For example, businesses that rely on seasonal sales periods to shift a lot of products may need more working capital than businesses that make steady sales throughout the year.
While it’s possible to run a business for a period of time with negative working capital, SMEs should try and maintain positive working capital as often as they can. Very high working capital could be a sign that your business isn’t taking advantage of new business opportunities, has over-invested in inventory, or that you’re slow to collect on outstanding debts.
How to increase working capital
Businesses can increase their working capital by making small changes to some of their processes, including:
Changing invoice payment terms
Shortening the payment window of your invoices can help boost working capital. You should start to see payments coming in more quickly and have more cash on hand before outgoing payments are made.
If you are worried about annoying your existing customers (especially those who may pay on time) you can shorten your invoice payment terms with new clients.
On the other end, you can also ask suppliers for longer payment terms. This is easier to do with service providers who you have long-standing relationships with and ones that you have a history of paying early or on time.
Taking stock of expenses
If you have low working capital, it could be time to reassess your business outgoings. Just like with personal finances, businesses can find themselves experiencing lifestyle creep too.
Assess how much your business is spending on non-essential items like work trips, break room snacks, or expanding your office space beyond your current needs. Don’t like the idea of cutting back in these areas? You could also evaluate your service providers and look for cheaper internet and utility suppliers.
Avoiding investing in fixed assets
While there’s nothing wrong with expanding your business by investing working capital in a larger location or equipment, it’s not always the best way to leverage your money. Fixed assets aren’t easy to sell if your business needs access to cashflow in a hurry. New equipment also devalues quickly. Instead, commit working capital to practices that help you produce more like marketing campaigns or hiring more staff.
Reducing debt and increasing assets
Want to improve your working capital? Pay off your short-term debts and then focus on building up your cash reserves or inventory. It’s always good to have money in the bank or inventory already paid for.
Paying off debts also means you’re more likely to be approved for a business loan in the future.
Access your equity with a working capital loan
With a working capital loan, SMEs can access their equity without refinancing. A working capital loan can be used to hire more staff, purchase new inventory, invest in marketing, or make GST or payroll tax payments, without having to spend your cash reserves.
At ThinkCap we can finance between $5k and $500k in working capital. Get access to a fully unsecured loan without having to offer any security through property or general security of your business. Apply now.
