Managing your working capital is a key component of the day-to-day running of a business. Making sure you have enough money coming into the bank to pay for stock, day-to-day items needed to run your business and other expenses can be a tough balancing act.
Working capital is one of the most important parts of this equation. It is the difference between the value of a business’s current assets such as stock, real estate, intellectual property and cash, and its current liabilities such as rent payments, payroll and and loan servicing.
Working capital can be in surplus or in deficit. For instance, let’s say that Business A has $100,000 in stock and its trademarks are worth another $25,000. If the business owes $50,000 in rent and $50,000 in salaries, you would say the business had a working capital deficit of $25,000.
Business B, having similar trademaks, owns $100,000 in stock and it only owes $25,000 respectively in rent and salaries ($50,000 in total). You would then say it has a working capital surplus of $50,000.
What is the optimal working capital ratio?
The right working capital ratio of current assets to current liabilities will differ for every business and it is not unusual for a business to experience a shortfall that takes it into negative working capital.
For instance, there might be a mismatch in the business’s payment cycle, when more money is being spent than is being earned, such as when a shop buys stock ahead of putting it out for sale. Seasonal businesses which are busy only at certain times of the year, often require a cash flow boost during quiet times that can be settled during busy season.
In reality a business’s working capital ratio is always changing. But a good rule of thumb is for it to be between 2:0 and 1:2. If you find the business’s working capital ratio is too high, that is, current assets substantially exceed current liabilities, there is a range of strategies you can use to speed up the inventory cycle, such as applying promotional prices on slower-moving inventory items. Longer term, you could reduce this issue by ordering stock items that don’t sell quickly less frequently and speed up the ordering cycle for fast-moving goods.
How should I finance my working capital?
Many businesses rely on a line of credit to finance their working capital requirements. There are two options which most businesses consider.
The first is a working capital loan, where funds will typically be credited to a business’s bank account periodically, for instance every 13 weeks. When weighing up your options for this type of finance, it’s a good idea to consider variables such as the interest rate you will pay, any collateral you will need to raise to access the funds, the loan’s term, fees and the frequency of repayments.
The other option is an overdraft. Unlike a working capital loan, it is a line of credit that is always available to access when the business is short of cash. Just as with the working capital loan, you will need to consider the interest rate you will pay, fees and collateral.
Businesses typically use an overdraft for short-term cash requirements and turn to a working capital loan for ongoing funds. In fact, many businesses have both facilities in place to help manage their cash flow cycle.
Both facilities also allow the business to use cash flow to fund growth opportunities such as developing new products and services.
What’s right for your business?
The right path for your business when it comes to cash flow funding will depend on the industry in which it operates, the risk appetite of the owners and maturity, as younger businesses tend to be more inclined to pursue growth opportunities than more mature ones, though there are notable exceptions.
No matter what your business’s individual circumstances are, the aim of taking an active approach to working capital management is to give the organisation options and a cash flow buffer year-round and through different business cycles.
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Written by Alexandra Cain