If you’ve ever heard the phrase, cash flow is king, it’s talking about the working capital requirements of a small business. It’s not uncommon for businesses, large and small, to fund working capital needs rely on working capital financing, but before you borrow, you should make sure you really understand what your working capital needs are and the formulae you’ll need to make sure numbers make sense.
Working Capital From the Accounting Perspective Simplified
The definition of working capital your accountant would likely share with you is: Working Capital = Current Assets – Current Liabilities. It’s not enough to simply have cash in the bank at the end of the month. Your current assets are made up of cash in the bank, your current Accounts Receivable, and your inventory. Your liabilities are defined as your current Accounts Payable and any long-term payables (think small business loans, lines of credit, etc.) your business may have. If you divide the value of your current liabilities into your current assets, you’ll come up with a ratio of assets to liabilities—the goal should be to shoot for twice as many assets as you have liabilities (or a 2:1 Ratio). Anything below a 1:1 ratio is a giant red flag that you have negative working capital—even if you have cash in the bank at the end of the month.
In terms of small businesses, it might make more sense to consider the formula in terms of the average number of days it takes your inventory to turn over, how quickly you need to pay for that inventory, and the average number of days it takes for your customers to pay you. If you’re customers don’t pay you quickly enough to meet your financial obligations to your suppliers (or your inventory sits on the shelf too long—tying up capital that could otherwise be used to increase revenue and profits), you will have trouble meeting your working capital needs out of cash flow.
In other words, staying on top of your average inventory turns is just as important as monitoring your Accounts Payable and Accounts Receivable to maintain a ratio of 1:1 or better—with the goal of 2:1.
It’s not uncommon for businesses to struggle fueling their working capital needs with their Accounts Payable alone. Many businesses turn to financing to bridge the gap using a combination of net profits and borrowed funds to meet the shortfall. Nevertheless, any financing you use for working capital becomes a liability and needs to be included in your ratio, so if you’re not careful, you could negatively impact that metric by borrowing and make your business unprofitable.
This may sound like a bunch of accounting mumbo-jumbo, but this is a very important ratio to understand. And, it’s fair to say that most businesses never attain the 2:1 ratio (but then again, roughly half of all the businesses that start today will be out of business within five years). Supporting evidence of the importance of this metric.
Does Working Capital Financing Make Sense for My Business?
Once you understand your working capital needs, and whether or not you have the internal cash flow to meet all those needs, it could make sense to consider borrowing to cover any short-term gap. For example, retailers might borrow to fund seasonal inventory build up or businesses like landscape contractors might borrow to bridge from one season to the next. However, if you don’t have the cash flow to make the periodic payments for a short-term working capital loan, it may not be the right approach—particularly if it throws your ratio into negative territory.
Businesses that traditionally have seasonality in their working capital requirements can (and should) plan ahead to anticipate those needs. In addition to your Accounts Receivable, there are several sources of capital to finance your working capital needs:
- Trade Credit: If you are on good credit terms and have a good relationship with your vendors and suppliers, it’s possible to negotiate payment terms to accommodate the seasonality of your business. Suppliers are often amenable to working with their best customers when they need to fund a large order to ramp up a new contract or bridge a short-term need for additional working capital by extending payment terms. Of course, you’ll likely have greater success negotiating with a supplier if you’re currently on good payment terms with them.
- Factoring: This is a popular way to free up working capital within the textile business because the manufacturing process can be long and the payment cycle might not be very quick. Basically, you’re selling your Accounts Receivable at a discount to have access to the capital now, rather than wait for the manufacturing and payment process. If you offer your regular customers payment terms and invoice for your goods or services, factoring could be a financing option for you.
- A Line of Credit: Lines of credit can be more difficult to qualify for than a short-term small business loan, but for those that qualify they offer the ability to access a credit line when you need it, pay interest on the amount of credit you use, pay off the balance, and use it again. Lines of credit are available from both traditional lenders like a bank or credit union, as well as online lenders like OnDeck.
- A Short-Term Small Business Loan: A short-term business loan (think in terms of three to 12 months) could be a good option for financing a small business’ working capital needs. Depending on your credit profile, the industry you’re in, and the overall health of your business, you could have more than one option available to your business—including a short-term small business loan.
Does OnDeck Offer Short-Term Working Capital Financing?
Since 2007 OnDeck has delivered over $6 billion to small business owners to buy inventory, take advantage of business opportunities, handle emergencies, repair equipment, and other working capital-related needs. Click HERE if you’d like to apply for an OnDeck loan.