About Working Capital Financing
A type of financing called working capital financing is intended to increase the amount a business owner requires for various purposes. These funds can be used to fill in cash flow gaps or for business expansion, and everything in between. This financing allows borrowers to access the working capital they plan to return shortly. To determine how much working capital you have, you will need to know what your assets and liabilities are.
Large and small businesses often use borrowed capital to meet their financial needs. Before you even consider working capital financing, it is essential to understand your financial needs and the formulae that you need to make the numbers work.
Working Capital from the Accounting Perspective Simplified
Your accountant will likely share the following definition of working capital with you: working capital = current assets – present liabilities. It is not enough to have cash in your bank at the end of the month.
Divide the current liabilities by your assets, and you will get a ratio of current assets: to current liabilities. A 2-1 ratio is the goal. You should aim to have twice as many assets as current liabilities. A ratio below 1-1 between current assets and current liabilities is a red flag. It can signify that you have negative working capital, even though you may have some cash at the end.
For small businesses, think about the formula in terms of the time it takes for inventory to turn, the amount of inventory you have to pay, and how long it takes for customers to pay. Suppose you need to receive payment from your customers quickly enough to fulfill your financial obligations to them (or your inventory is left on the shelf for too long, tying down capital that could be used to grow revenue and profits). In that case, you will struggle to meet your cash flow needs.
It means that it is equally important to monitor your inventory turnovers and accounts payable and receivable to maintain a ratio between 1-1 and better. The goal is 2-1.
Working Capital Financing Available for Small Businesses
Small businesses often need help meeting their working capital requirements with accounts payable. Businesses often turn to borrow funds and net profits to cover the shortfall. However, any working capital financing becomes a liability and must be included in your ratio. If you take care, borrowing could positively impact your business’s profitability and prevent it from going.
Although it may sound like accounting jargon, you need to know this is a critical ratio. Most businesses will never achieve the 2-1 ratio. It is even though roughly half of all businesses started today will go out of business in five years. It supports the importance of this metric.
Is working capital financing a good option for my business?
It is worth assessing your current working capital requirements and determining if you have sufficient cash flow. If unsure, consider borrowing to fill any short-term gaps. Retailers might borrow money to finance seasonal inventory building, while landscape contractors might borrow money to bridge the gap between seasons. If you need more cash to pay the monthly payments of a short-term loan, this may not be the best approach, especially if your ratio is negative.
Businesses with seasonality in their working capital needs can plan and be prepared for them. Many sources of capital can finance your working capital requirements and accounts receivable.
- Trade credit: If your credit is good and you have good relationships with your suppliers and vendors, it may be possible to negotiate payment terms that accommodate seasonality in your business. Suppliers often work with their top customers to finance large orders or bridge short-term cash flow gaps. You’ll have more success when you are on good payment terms.
- Factoring: This is a popular method to raise funds in the textile industry. The manufacturing process can take a long time, and payment cycles may take time. You are selling your receivables at a discount to access working capital immediately instead of waiting for the manufacturing process and payment. Factoring is a financing option if you offer regular customers payment terms and an invoice for your goods and services.
- A line of credit: It can be harder to get a loan for a small business than for a long-term, short-term credit line. However, lines of credit allow you to access credit when needed. You pay interest on the credit amount you use, repay the balance, and then you can use it again. Online lenders such as Commercial Lending USA and traditional lenders such as banks or credit unions can also offer lines of credit.
- A short-term small business loan: Small business loans with 3-12 months are a great option to finance working capital. Your credit score, industry, and overall business health will all affect your options. You may have multiple options available for your business.
