Understanding working capital and how you can use it to optimize your business
Every business needs money on hand to operate, especially to cover everyday business expenses. This is where working capital is your business’s best friend.
Working capital can help grow your business, remain afloat during “off seasons” and tough times, and take advantage of bigger projects. You can use it to expand during the good times and survive during the hard times.
Working capital can be used to cover all your expenses due within a year, such as:
- Payroll
- Debt payments
- Rent
- Taxes
- Purchasing inventory
- Daily running costs
It can also be used to invest in growth, fund projects, and smooth out your cash flow
How does working capital work?
Working capital reflects the money you have on hand to cover your immediate expenses.
You can calculate your working capital by subtracting the value of your current liabilities from the value of your current assets. Assets can include cash or things that are easy to liquify within a year: inventory, short-term investments, and accounts receivable. Liabilities include anything that is due within a year – your debts, payroll, taxes, and accounts payable.
Here’s the equation:
Current assets – Current liabilities = Your working capital
Even if you have positive cash flow, you may still have negative working capital if you have large debts. Keeping an eye on working capital is a great way to get a feel for the liquidity of your business and ways you can optimise your cash flow.
How much working capital do I need?
Having more working capital indicates that you’re in a better financial position – but how much you need can be very different across different industries.
If your revenue ebbs and flows seasonally – for instance, in retail or hospitality – you may need more working capital on hand. This can help with higher expenses in the off-season and filling in gaps in your cash flow.
Calculating your working capital requirements depends on a key factor: your cash conversion cycle. This is a measure of how fast you turn inventory into sales, and sales into cash. The shorter your conversion cycle, the faster you can get cash into your business to pay for immediate expenses.
To figure out your cash conversion cycle, add your inventory days (how long you hold stock) to your receivable days (how long it takes customers to pay – or accounts receivable), and subtract your supplier payment days (how long it takes your business to pay your suppliers – or accounts payable).
Here’s the equation:
Inventory days + Receivable days – Supplier payment days = the number of days in your cash conversion cycle.
You can use this number to estimate your working capital requirements by multiplying it by your average daily sales. If this estimate is higher than your current working capital, you may need to get creative about improving it – or consider applying for a working capital loan.
How can I improve my working capital?
One way you can improve your working capital is by shortening your cash conversion cycle. This can be done by:
- Invoicing quickly and correctly
- Renegotiating payment terms with suppliers so that you can pay later
- Make payment easy for clients and encourage early payments
- Requiring deposits from clients
You can also try:
- Taking advantage of tax incentives
- Trading short-term debt for long-term debt
- Selling your long-term assets for cash
- Analysing your costs
When to consider taking out a working capital loan:
Working capital loans are a fast, flexible funding option that can inject the cash you need to support day-to-day business operations.
A working capital loan might be right for you if:
Your business has cyclical/seasonal cash flow:
If your revenue is higher during some periods than others, a working capital loan can help smooth things out, cover expenses in your “off” seasons, and help you prepare for busy periods.
You have obligations to the government, employees, or suppliers that are due before payments come in from customers:
Most businesses find themselves in this tricky position at some point – a working capital loan can come to the rescue.
You want to take advantage of supplier discounts:
A working capital loan can give you the extra cash you need to buy in bulk and reap big savings from supplier discounts.
You’re working on a project:
You may need a working capital loan to help fund a temporary project to improve your business, or to pay temporary employees.
At ThinkCap, we’re here to help your small business succeed. If you think a working captial loan could be the right option for you, apply with us today. We finance between $5k and $500k in working capital, with same-day funding approvements. To apply, minimum turnover must be $10k per month. Get up to $250k financed with bank statements from the past 12 months, paid out in lump sum payments.
