early 30% of small businesses fail because they run out of capital, otherwise known as cash reserves. In fact, low working capital is one of the main reasons new companies go belly up. This statistic underscores how crucial it is to understand how working capital works.
If you’re a small business owner hoping to obtain a better grasp on this key financial indicator, then read further to learn what working capital is, how it affects both present and future business operations, and what straightforward tips you can apply to boost company capital.
How to Calculate Working Capital
First, let’s define how to calculate your “net” working capital, which is the difference between your company's available assets minus any active liabilities. Companies with a high, positive working capital have a better chance of growing and attracting investors.
Assets could include:
- Property and equipment
- Accounts receivable
- Cash and cash equivalents
Liabilities could include:
- Bills payable
- Income taxes payable
- Accrued expenses
- Short-term loans
- Accrued payroll
To determine your business’s working capital, follow this simple formula.
Current assets - current liabilities = working capital
As assets and liabilities increase or decrease, working capital fluctuates accordingly. For a new business owner, this volatility can result in serious financial and operational stress.
Why Is Working Capital Important?
According to a small business study by Goldman Sachs, low working capital may lead to an inability to expand to new markets, downsizing, and canceled investments. It may even contribute to the national unemployment rate.
Small businesses are more likely to experience labor shortages and feel the lulls and booms of the economy than larger corporations. Sales can be seasonal. Industries can dip. Recessions can hit. Put simply, small businesses with lots of cash or high working capital may find it easier to withstand fluctuations in cash inflow. Whether covering expenses during any off-seasons or enabling a business to operate with greater confidence in case they face a serious economic downturn, high working capital can act as a safeguard against volatility.
High working capital also makes it easier to cover the costs of day-to-day operations, avoid debt, and invest in growth strategies.
On the other hand, a business with low working capital may struggle to meet liabilities or continue business functions, such as making payroll or purchasing inventory.
A rapidly growing business that is unaware of its working capital status may be scaling on a shaky foundation. At the same time, a struggling business can quickly flourish after managing to increase working capital.
How to Increase Your Working Capital
Once you understand the impact of working capital on your business, it’s time to prioritize it. If your working capital isn’t as robust as you would like, or you want to boost an already-impressive capital amount even further, then consider taking the following steps.
1. Negotiate contract terms
Are you paying your suppliers and service providers on delivery while awarding clients with extended net terms? It may be time for negotiations on both sides.
Ask suppliers and providers for lengthened net terms. This will likely be easier if you’ve been with your supplier long enough to have established a positive payment track record. And when working with new providers, negotiate flexible payment terms from the start.
For clients, immediately tighten payment windows for new contracts. To avoid ruffling the feathers of existing customers, communicate upcoming net term changes with plenty of warning.
Successful negotiations with both parties will lead to higher working capital. The more payments that come in before outgoing payments are deployed, the more time you can devote to improving operations rather than compensating for low cash flow.
2. Evaluate expenses
Even the most budget-conscious small businesses can sometimes waste financial resources. As a small business owner, question every expense, no matter how necessary it may seem at first.
- Can a portion of current business trips be moved to virtual meetings instead?
- Is this much office space a luxury or a necessity?
- Can the office break room be stocked with less expensive (yet still delicious) snacks?
Also, evaluate technology, credit card, and banking fees. Focus on reducing spending without compromising efficiency or the customer experience.
Just remember that eliminating bonuses or increasing workloads to reduce payroll can crush team morale and may have even more of a negative effect than low working capital.
3. Place growth practices ahead of fixed assets
Small business owners often make the mistake of pouring working capital into fixed assets, like a larger location or updated equipment. While these purchases might be necessary, they’re not always the best use of working capital.
Instead, commit working capital to growth practices, such as a marketing campaign to get your business in front of more potential clients. Not only can this be a better use of capital, but it’s also a way to improve overall cash flow.
For example, new equipment may improve operations, but its value begins to deteriorate immediately, reducing current assets. On the other hand, a smart marketing campaign that leads to new customers can boost sales (and working capital) indefinitely.
Leasing fixed assets can make more financial sense, especially for companies with low working capital. Purchases should be something you grow into, not make to grow.
4. Secure a working capital loan
A working capital loan can quickly make up for a sudden dip in cash flow. But because a business is more likely to be approved for a loan if they can prove some existing positive working capital, applying for a loan can feel like a catch-22. However, here are a few things you can do to improve your chances of approval.
First, know the requirements. Every lender will have different minimum qualifying guidelines for personal and business credit scores, minimum time in operation, and annual revenue amounts.
Next, take the time to research and compare lenders. Consider different types of small business loans along with their annual percentage rates (APRs), which reveal the true cost of the loan.
Finally, gather the required documentation and submit a formal loan application. And, of course, ensure you fully understand the presented terms and conditions before agreeing to receive a working capital loan.
Working Capital Is a Necessity for Growth
For small businesses in virtually every industry, having a firm understanding of working capital is vital. Know what your balance sheet reflects in relation to working capital, react and respond appropriately, and enjoy the growth that can follow.
This page is for informational purposes only and is not intended to be relied upon as legal, financial, or accounting advice. Please consult your own professional if you have any questions.