Working capital for companies

One of the biggest needs that small businesses have is the need to working capital. Working capital is the lifeblood of the business, the fuel that finances day-to-day operations and the ability to pursue short-term growth opportunities for the business. Working capital is officially defined as “…”. The financial equation to determine working capital is as follows:
(Accounts receivable + inventory + cash on hand) – (Accounts payable + prepayment)

There are numerous sources of working capital for businesses. Looking at the equation, one way to get additional working capital is to increase accounts receivable (i.e. sell more) or convert accounts receivable to cash by getting customers to pay sooner. Continuing with the examination of the equation, another way is to increase inventory. When examining a company’s balance sheet for the purpose of acquiring that company, it is important to examine how these parameters fluctuate as part of working capital. A business can significantly increase inventory and accounts receivable, dramatically increasing the amount of “working capital” listed. However, those accounts receivable could be essentially uncollectible and the inventory could become obsolete. Either of these would essentially nullify the advantages of a large “working capital.”

You can access cash by having customers pay for their orders in advance by offering significant discounts for doing so. For example, if a customer buys a monthly service for $100, he may offer you a discounted annual prepaid rate of $1,000. That’s about a 20% discount, but when you factor in the time value of money, the discount falls to between 5 and 8% (depending on your internal rate). If you sell much larger service contracts or products, the difference in actual cash can be profound with prepaids. On the other side of the equation, you can have your provider(s) extend deadlines. Instead of payment expected within 15 to 30 days, you may be able to postpone payment to 90 days. You never know unless you ask.

From the perspective of the business owner, the higher the ratio of working capital to cash, the better. Cash can be spent on anything: paying suppliers, paying employees, paying rent, paying for geographic expansion or product line development. Accounts receivable and inventory that are not quickly converted to cash through turnover must be converted to needed cash through financing that uses one or both of these two as collateral for loans.

Working capital for business is something many small business owners don’t plan for. They often don’t think about it until they come across a cash crisis. Or sometimes not until they’ve faced a series of cash problems and are tired of the stress of not knowing how they’ll pay payroll or pay angry vendors.

Some of the countless sources of financing working capital for companies They include short-term asset-based lines of credit, term loans, equipment loans, dedicated lines of credit, vendor financing or extended payment terms, economic development grants, and factoring. Loans against accounts receivable and inventory are generally short-term lines of credit, renewable annually. Some banks and other financial institutions will extend a three- to five-year term loan against a high-grade collateral. (ie accounts receivable that typically pay within 30 to 45 days and are with highly creditworthy customers and inventory that is replaced within a similar time frame).

The important thing is to continually keep in mind what “working capital” is and what goes into it. It is vitally important to keep track of your company’s cash and how quickly your company converts its short-term assets into cash. Failure to do so can result in a significant shortage of working capital and, before long, a liquidity crisis. If your business qualifies for a line of credit, get one. You don’t have to use it, but you should have it on hand to use in a crisis. I have had clients who have lost important clients to bankruptcy. That unfortunate scenario happened more often in 2010 and 2009 than in previous years, but it could happen at any time. If your customers have large accounts receivable outstanding that are close to 90 days old, your exposure to such a scenario is drastically high. Even if your risk is low, when a customer can’t or won’t pay accounts receivable in a timely manner, where will your cash come from to run the business while you take care of the problem? Plan for the future and keep track of your working capital. Your business will thank you in the form of stronger financial health.

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Category: Business