One of the biggest needs that small businesses have is the need working capital. Working capital is the company’s lifeblood, the fuel that funds the day-to-day operations and the ability to pursue short-term growth opportunities for the company. Working capital is officially defined as “….”. The financial equation for determining working capital is as follows:
(Accounts receivable + inventory + cash at hand) – (Accounts receivable + prepaid)
There are several sources of working capital for companies. Looking at the equation, one way to obtain additional working capital is to increase accounts receivable (ie sell more) or convert the receivables into cash by getting customers to pay faster. Continuing to research the equation is another way to increase inventory. When examining a company’s balance sheet for the purpose of acquiring that company, it is important to examine how these parameters fluctuate as part of working capital. A company can significantly increase its inventory and receivables and drastically increase the amount of “working capital” specified. However, these receivables cannot be substantially collected and the stock may be obsolete. One of these will essentially cancel out the benefits of a large “working capital”.
You can access cash by getting customers to prepay their orders by offering significant discounts to do so. For example, if a customer buys a monthly service for $ 100, you can offer them an annual prepaid, discounted rate of $ 1,000. It is approx. 20% discount, but when you take into account the time value of money, the discount drops by 5-8% (depending on your internal rate). If you sell much larger service contracts or products, the difference in actual cash can be profound with prepaids. On the other side of the equation, you can have your supplier (s) extend the terms. Instead of the expected payment within 15-30 days, you may be able to push the payment out to 90 days. You never know unless you ask.
From the business owner’s perspective, the greater the share of working capital in cash, the better. Cash can be used on everything – to pay suppliers, pay employees, pay rent, pay for geographical expansion or product line development. Receivables and holdings that are not quickly converted into cash through revenue must be converted into needed cash through financing, using one or both of these as collateral for loans.
Working capital for businesses is something many small business owners do not plan. They often don’t think about it until they encounter a cash crunch. Or sometimes, not until they have encountered a series of cash crunches and are tired of the stress of not knowing how to make payrolls or pay annoying vendors.
Some of the myriad sources of funding working capital for business includes short-term asset-based credit lines, short-term loans, equipment loans, signature credit lines, vendor financing or extended payment terms, financial development grants and factoring. Typically, loans against receivables and stock are short-term credit lines that can be renewed annually. Some banks and other financial institutions extend a three to five year loan against high quality collateral. (i.e., debtors who typically pay within 30-45 days and are with customers with a high credit rating and inventory that are replaced within a similar timeframe.)
The important thing is to constantly remember what “working capital” is and what goes into it. It is very important to track your business cash and how quickly your business converts its short term assets into cash. Failure to do so can result in a significant shortage of working capital and, in short, a liquidity crisis. If your business qualifies for a credit line, get one. You do not need to use it, but you must have it available to use it in the event of a crisis. I have had clients who have lost larger customers to bankruptcy. This unfortunate scenario occurred more often in 2010 and 2009 than in previous years, but it could happen at any time. If your customers have large outstanding receivables close to 90 days, your exposure to such a scenario is drastically high. Even if your risk is low when a customer cannot or does not pay receivables in a timely manner, where will your cash run the business from while you are handling the problem? Plan for the future and track your working capital. Your company will thank you for it in the form of stronger financial health.