The number one reason new small businesses fail within the first two years is the lack of working capital. Even when you start a new business, you need start-up working capital, as the company does not yet produce the amount necessary to sustain its activity. While the start-up working capital typically comes from investors, it is up to you to further develop the business and get it ready to become self-sustained.
What Is Working Capital?
The working capital is represented by all the liquid assets that a company owns. Working capital is needed to cover both expected and unexpected expenses, such as salaries, bills and material purchases, and help the business grow. When working capital is negative, attracting investors or getting loans can be quite a challenge. But how does one determine a company’s working capital?
To calculate the working capital of a company, accountants use a simple formula: the working capital is the difference between a company’s current assets and its current liabilities.
Broadly speaking, business assets represent all valuables that a business holds and they can be both tangible (vehicles, equipment) and intangible (copyright, patents) items. Eventually, all assets need to be converted to cash, in one way or another. Current assets are all business assets that will be converted to cash within the next year. They are typically composed of liquid cash, accounts receivable and inventory that can be quickly sold and turned into liquid cash.
Liabilities, also called accounts payable, consist of the amount of cash a company owes (loans, credit cards, mortgage). Current liabilities or short-term liabilities are obligations that a business needs to pay off within one year. They include sales taxes, payroll taxes and monthly loan payments.
The strategy developed by a company to analyze and monitor the working capital, ensuring it has enough cash flow to meet costs and obligations is called working capital management.
How Does Working Capital Management (WCM) Work?
WCM includes the management of accounts payable and accounts receivable, as well as inventory management. Its main objective is to minimize spending and maximize investment returns. Working capital management includes a number of key elements:
Working capital ratio: is calculated as current assets divided by current liabilities. Based on this ratio, one can determine the financial health of a company. While numbers may vary, depending on the industry, a ratio below 1.0 usually indicates financial issues, numbers between 1.2 and 2.0 indicate stability and a ratio above 2.0 may suggest the company’s ineffective use of assets to increase revenue.
Collection ratio: indicates how effectively a company manages its accounts receivables. To calculate it, accountants divide the total number of receivables by average daily sales and the number resulted represents the average number of days within which a company receives its payments. A lower number represents cash flow efficiency.
Inventory management: is used to ensure the company operates with maximum efficiency. In order for that to happen, the business has to maintain enough inventory to meet the customers’ needs and at the same time avoid unnecessary items that don’t efficiently turn into cash.
Ways to Increase Working Capital
Working capital is necessary to maintain your business, but also help it develop. Without having enough working capital, you would not be able to provide inventory to service new customers when, for example, a competitor gets out of the market and you want to attract their clients. There are various means you can increase your working capital:
Invoice as soon as possible
It is important to maintain a good relationship with your customers, while at the same time making sure you don’t allow them to exceed the due date too much. Protecting yourself from late payment by invoicing as soon as the products are delivered will ensure you maintain your capital and keep your business running. A good way to improve collections is to offer customers some sort of motivation to pay their invoices as soon as possible.
Take out a loan
Taking out small business loans to secure your assets is a way better option than using cash. You will be able to recuperate the interest costs by providing customers with services or products more quickly. Many suppliers offer various types of discounts if you pay your invoices before the due date and this way you will be able to absorb the cost of the loan in time. A loan can also help you keep your inventory packed in order to fulfill client requests, which will be turned into accounts receivables.
Review interest payments
From time to time, you might be able to renegotiate your loan interests based on your payment history. Talk to your lenders and ask if they can offer you a different payment schedule, with a lower interest rate. All the saved money can be added to your working capital and increase its ratio.
Negotiate with the suppliers
Start by reviewing your existing contracts with the suppliers and renegotiate the initial prices. If you are an old client, chances are they will offer you some sort of discounts. If they refuse, do some research and find out if other suppliers have better prices. While loyalty is important, don’t let it stand in the way of your business growth.
Crowdsourcing is a good option for entrepreneurs to increase working capital. This way you can attract investors that will provide capital. The way crowdsourcing works is you list your business on a platform and investors can choose to fund it, receiving goods or stock shares as a payback.
Keep good inventory management
By not overstocking your inventory with unnecessary goods, you ensure all products generate cash fast enough to become current assets. At the same time, keeping your inventory too low will delay sales and even make your company lose clients. Keep an eye on the time it takes for products to sell and make sure you don’t keep your inventory under or overstocked.
Cut unnecessary expenses
Keep good track of your budget and pay attention to where your money is going. Take a look at your company’s income and expenses and limit all payments that don’t improve your working capital. Even though they may seem like small expenses, they all add up and make you lose money.