What is working capital?
Working capital is a term that gets thrown around a lot, but what exactly does it mean? Let's start out with the technical definition:
Current Assets - Current Liabilities = Working Capital
Current assets include cash, accounts receivable, inventory, investments, and any other assets that can be liquidated fairly quickly. Current liabilities are obligations that are due within one year, which includes accounts payable, the portion of long-term debts that is due within one year, and any other short-term obligations.
In a perfect world, current assets should exceed current liabilities. That means the company has sufficient liquid resources to meet its near-term obligations. If current assets are less than current liabilities, then the company is facing a liability squeeze. On the other hand, if current assets are more than twice as high as current liabilities, the company is not using its capital to best advantage.
Working capital is one of the most important indications of a well run business, and virtually every business needs a positive working capital balance in order to survive and prosper. It's also an important factor for banks in extending credit to a business owner.
What are the uses of working capital?
One of the reasons why working capital is so important is that it can be used in so many different ways that are virtually critical to the survival of the business. It represents an essential source of capital particularly during those times when business revenue isn't fully covering business expenses. For example, working capital can be used for any of the following expenses:
- Purchasing inventory - especially when it needs to be acquired before an expected busy season
- Hiring new employees - the expense of new employees typically precedes the revenue they will generate
- Payment of taxes - whether your revenues are high or low, taxes must be paid when they're due; you may need to pay them out of working capital if business revenue won’t cover them
These are just three examples of how working capital can be used, there are many, many more. You should think of working capital as being money available when business revenue isn't.
How your working capital can benefit your business
A healthy working capital position is absolutely critical to the survival of any business. Benefits of having healthy working capital include:
Ability to weather short-term rough patches. All businesses experience seasonal fluctuations in cash flow; working capital enables you to even out the business cycle.
Ability to grow your business. Working capital could enable you to purchase inventory for a new product line that will enable you to expand sales.
Ability to acquire new income generating assets. This could be a new computer system, a more sophisticated communication system, or processing equipment that would enable your business to operate more efficiently or increase your income.
Buying out a partner. Many businesses today are service-oriented, and not capital-intensive. A few thousand dollars might buy out of business partner; it's usually better to do that out of working capital, than by taking on long-term debt.
Sources of working capital
There are various ways that business can acquire working capital:
Additional business owner capital. If the business owner has financial assets outside the business, he or she could contribute cash or other short-term assets to the business. This can include the proceeds of personal loans, such as from credit cards or a second mortgage on a personal residence.
Bringing in new investors. A new investor can make a cash contribution that will immediately increase current assets, and provide working capital. The disadvantage is that the original owner will be giving up both equity and profit share, as well as control.
Sale of business assets. This can raise working capital, but it also has the potential to hurt future cash flow, as that asset will longer be available to generate revenue.
Business loans. This is usually the preferred route to acquire working capital. In fact, many businesses have relationships with certain lenders that enable them to take loans for working capital on an ongoing basis. You can check out our comparison page to learn about some of the best small business lenders in the market.
However you acquire working capital, make sure that you always have source. You can never know when your business income will fall, or your expenses will suddenly rise.
Working capital will allow your business to continue and to grow no matter what happens.
One way to ensure a healthy and strong working capital is by collaborating with a suitable lender that has the strength and financial immunity to offer ongoing cash flow to fit your needs. Kabbage is a premium loaner that offers creative working capital solutions for all business types.