Article Summary: In order to understand working capital financing, you need to understand your current working capital ratio. If you divide your assets by your liabilities you'll come up with a ratio of assets to liabilities. Your accountant will probably suggest you should have a 2:1 ratio. In other words, you should have twice as many assets as liabilities—a pretty tall order for many small business owners. That being said, anything below a 1:1 ratio should be considered a big red flag that you are in negative cash flow territory. So when looking at working capital financing, you'll need to know that you have the cash flow to repay a loan and that borrowing won't negatively impact your cash flow ratio.
There are several good sources of working capital financing in addition to a traditional loan at the local bank, they include:
- Trade Credit or Payment Terms from your suppliers
- Accounts Receivable Financing or Factoring
- A Short-Term Small Business Loan
- A Business Line of Credit
If you've ever heard the phrase, "Cash flow is king," it's talking about how important working capital is to building a successful and thriving business. Keep reading to learn more about working capital financing and how you can leverage it to find success.
What is “working capital”? And how can it help my small business?
These are just a couple of questions we get every day, here at OnDeck, so I thought it would be prudent to do a little review.
Cash flow is the heartbeat of a small business. For many business owners, it makes sense to borrow funds to create a liquid cash cushion to operate their business to the best of their ability. Before you decide to borrow, you need to understand what your working capital needs are and to make sure numbers make sense for you and your business.
According to OnDeck’s small business educator, Ty Kiisel, Working Capital Financing is easy to understand. In the video below, Ty explains what working capital is, what you need to know before you borrow, and which business needs work best for financing.
The definition of working capital your accountant would likely share with you is:
Working Capital = Current Assets – Current Liabilities.
Your current assets not only make up the total amount of cash in the bank, but it also includes your current Accounts Receivable, and your inventory. Your current liabilities include your current Accounts Payable and any long-term payables, (think small business loans, lines of credit, etc.)
To figure out your working capital ratio of assets to liabilities, you need to divide the value of your current liabilities into your current assets. Your goal should be to shoot for twice as many assets as you have liabilities (or a 2:1 Ratio). Most businesses will never reach a 2:1 ratio, so don’t think you’re doing something wrong if you don’t hit those numbers. You should keep in mind that if your ratio is below 1:1 you have negative working capital – even if you have cash in the bank at the end of the month. This is something you should address.
Because your current assets include your inventory, 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.
Does Working Capital Financing Make Sense for My Business?
Once you determine your working capital needs, and whether or not you have the internal cash flow to meet all those needs, it’s time to think about if working capital financing makes sense for your business. Do you need to cover a short-term gap? Will the funds you’re looking for borrow cover inventory that will pay for itself in a relatively short period of time? Keep in mind, 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 best option for your business at this time.
There are several sources of capital to finance your working capital needs. Make sure you familiarize yourself with your options to determine the best financing for your business. Here are 4 example of working capital financing:
1. Trade Credit:
Many suppliers are willing to work 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.
This is a popular way to free up working capital within the textile business. What you’re actually doing is selling your Accounts Receivable at a discount to have access to the capital now, rather than wait for the manufacturing and payment process.
3. A Short-Term Small Business Loan:
A short-term business loan is a true term loan with shorter terms than you may be familiar with. Short-Terms small business loans are classified at less than 24 months, and are often as short as 3 to 12 months.
4. A Business Line of Credit:
Lines of credit can be more difficult to qualify for than a short-term small business loan. However, for those businesses that qualify Lines of Credit offer the ability to access funds when you need it, pay interest on the amount of credit you use, pay off the balance, and use it again.
If you think working capital financing may be what you’re business needs. Here’s our Ultimate Guide to Small Business Financing, which goes into detail about each type of financing available for small business owners and how to assess the best options for your business.