WHY IS WORKING CAPITAL IMPORTANT?
What is working capital?
Working capital is the cash available by a business for its daily expenditures, it is also a measure of a business’ liquidity, efficiency and its short-term financial performance or overall health. It includes the cash, inventory, accounts receivable, accounts payable, the amount of debts due within a year, and other short-term accounts belonging to a business.
Why is working capital important?
Working capital is important because it is a reflection of the company’s activities in the areas of debt management, inventory management, revenue collection, and payment due to suppliers. It is very important that a company maintains enough cash flow to cover its payroll, inventory, marketing campaigns, and the numerous other financial obligations that may come up within daily business operations. This responsibility is also critical for sustaining the growth of the business. A company with a positive working capital is an indication that it is able to pay off its short-term liabilities within the shortest time possible. While a company with a negative working capital may fall into one or more of the following; either the company is becoming over-leveraged, is struggling to maintain or grow sales, is collecting receivables too slowly or paying its bills too quickly. Either way, this signifies that there is a problem within the company and that raises a red flag to analysts indicating that the business is unable to pay off its short-term liabilities on time.
How to calculate working capital
Some other interesting ways by which analyst evaluate a company’s working capital is by calculating the inventory-turnover ratio, the receivables ratio, the current ratio, days payable, and the quick ratio. Growing businesses that are planning on expanding would require a very solid financing solution for their working capital needs, and inventory has been identified as one of the most significant uses of working capital. The longer inventory is left not utilized, the longer the company’s working capital is tied up. There are also some instances where a business may fail due to w
orking capital shortages, even though they may actually turn a profit. This usually occurs when a business with plans for expansion runs out of cash due to poor management and investment decisions. They suddenly find themselves in a fix where they need more working capital to finance their expansion plans than they can generate in their present state.
What is the working-capital formula?
According to analysts, the timing and level of a company’s cash flows are the crucial factors determining whether the company can meet its liability obligations when due. When there is a default or late payment, the use of the working-capital formula usually comes into play. It assumes that the company would have to liquidate its current assets to pay its current liabilities. This assumption however is not entirely substantial as the company would also have to meet its payroll obligations and sustain workflow at the same time. The same applies to the accounts receivables which may not always be readily available for collection in many companies as assumed by the working capital formula.
What to do if a company needs working capital funding?
Ultimately, a business that cannot meet its short term liabilities on time may have to apply for a working capital loan. A working capital loan enables businesses to finance their daily operations despite their inability to cover their ongoing operating expenses. It offers businesses that are experiencing short term financial constraints the opportunity to buy time to generate revenue based on existing capital and resources. Businesses usually leverage these working capital loans as the solution to help finance their day to day operations. Although nowadays it is becoming increasingly difficult for businesses, especially entrepreneurs and small business owners to secure working capital loans from traditional lending institutions.
Traditional lenders usually require exorbitant personal guarantees for working capital loans such as the business owner’s home or some other highly valuable collateral. Alternative lenders who are supposed to serve as a cushion for businesses also experience cut throat competition among themselves thereby creating a wide gap between prime rates and predatory rates.
As a result, many businesses are adopting creative ways of acquiring working capital loans from a variety of sources. Some of the most common options being adopted include:
- Line of credit: This option allows borrowers to only pay for the interest applicable to the amount of money drawn. This typically 1 to 2% more than the bank’s prime rate but with no collateral.
- Short-term loans: Usually, this type of loan carries a fixed interest rate and payment period. Typical payback periods run in daily or weekly pulls from a business bank account to satisfy the loan. It is usually unsecured and borrowers with poor credit have a better chance of getting approved if they show surplus gross receipts.
- Equity funding via personal resources or investors: This refers to investment from friends, family or home equity loans. This option is perfect for new businesses without an established credit history.
- Accounts receivable loans: This option involves applying for working capital loans based on confirmed sales order value of our company. It may however be difficult accessing this loan facility if you don’t have an established track record for paying your debts.
- Invoice Factoring: This option comes in handy when you have a business that has invoices from customers. Selling the invoice at a discount to the lender freeing up funds right away.
- Trade creditor: Businesses use this option of acquiring working capital loans when their current or potential supplier agrees to offer a trade credit facility if they have an established history of large orders from the supplier. It is important to have a good credit history as the trade creditor will inevitably do a thorough check before granting the loan.
- Equipment Financing: Customers that are leveraging equipment to produce profits can get working capital in the form of equipment financing. This loan interest rate is typically 4-9% and can be a low cost option to grow a business and facilitate cash flow.
Securing a working capital loan is a quick way to finance a business. It is also one of the easiest ways to harness the potential of your business. A working capital loan acts as unsecured debt, hence they overrule the need for providing traditional collateral. It is a great way for small and existing businesses experiencing low cash flow to replenish themselves and solve their short-term financing issues in no time.
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