Understanding Working Capital: A Guide for Small Business Owners

As a small business owner, you know how important it is to have enough funds on hand to keep your business running. These available funds are known as working capital, and they are needed to run a healthy business.

Inadequate working capital levels are cited by the SBA Small Business Administration as one of the top reasons for small business failure. As such, learning about and securing proper levels for your company is crucial.

What is Working Capital?

Simply put, working capital is the difference between your current assets and current liabilities. Current assets are those that can be converted to cash within a year, while current liabilities are debts and obligations due within a year. Without enough working capital, you may not be able to pay creditors or meet your operating needs. But how do you know how much you have, and how much you need?

How to Calculate Working Capital

To determine how much working capital your business has, you can use this calculator. It calculates working capital by using four inputs – annual growth, current target ratio, total assets, and total liabilities. Annual growth refers to your expected annual growth for the next year, while the current target ratio is current assets divided by current liabilities. For most businesses, a ratio of around 2.0 is optimal.

There are a number of factors that influence how much working capital a business needs. For instance, seasonal businesses need more working capital to keep them afloat in the off-season and to meet the higher expenses that often occur during preparation for the peak season. When deciding how much working capital your business needs, consider your industry, growth rate, and fixed costs.

Working Capital Loans

So, now you know how much working capital you have, and how much you need. But where do you get it? Small businesses often need additional working capital to get through difficult periods. A working capital loan can help fill temporary funding holes and keep your business up and running. Working capital loans are designed specifically for small business owners who need short-term capital. These loans are often available through online lenders, and offer real advantages over traditional bank loans.

Working capital loans are generally easier to get approved, faster to get funded and more convenient to use, providing fast capital when you need it. Repayment periods tend to be shorter, months rather than years, as the loan is intended to get the business through a short-term cash flow problem.

Applying for a Working Capital Loan

When you apply for a working capital loan, lenders will consider several factors to determine if you qualify. Some banks will ask for your financial statements and a balance sheet, then they will check your business and personal credit scores, the length of time your company has been in business, and annual revenue.

Alternative lenders will not wholly rely on your credit reports instead they will review your actual business metrics and transactions in your accounts such as; bank, accounting software and credit card payment processors. You'll need to provide financial statements and a balance sheet.

Lenders vary in what businesses they prefer to lend to. Some will provide loans to businesses with credit scores below 500, as long as they are generating sufficient revenue or have been in business at least a year, while others require higher credit scores, greater revenue, and more years in operation.

Utilizing Working Capital

Now that you know how much working capital you have, you can think about the best way to use it to benefit your business. In addition to fixed costs, you can use working capital to build and improve your business. These monies can be used to pay for expensive equipment that often requires large upfront payments.

You can also fund your businesses expansion with new or remodeled office space, a second location, and other improvements are common. Also, you can expand your staff, hiring new staff and paying for their training. Every industry has its own best uses of working capital. Hair salons often invest in advertising campaigns while auto repair shops buy car accessories to sell and install in customer's vehicles.

Finally, working capital can provide a sense of security. With a generous cushion, you are prepared for any setback or unforeseen circumstance that may arise – which affect all small businesses. With sufficient capital on hand, you can rest easy, knowing that your business expenses can be met.

About the Author:

Marsha Kelly sold her first business for more than a million dollars. She has shared hard-won experiences as a successful serial entrepreneur on her Best4Businesses blog, where she also regularly posts business tips, ideas, and suggestions as well as product reviews for business readers. As a serial entrepreneur who has done “time” in corporate America, Marsha has learned what products and services work well in business today. You can learn from her experiences to build your business.