Working capital is the lifeblood of businesses of all size. Small businesses selling to other businesses on credit terms often have a cash flow crunch while waiting for payment on open invoices.
What Is Working Capital?
Working capital in business is defined as a company’s assets minus liabilities. Assets refer to inventory, cash, and accounts receivable. Liabilities refer to accounts payable and financing repayments. While a small business may see a positive gap between assets and liabilities, the assets may be hard to liquidate in a cash flow crunch. Slow-paying customers, insolvent customers, market changes, personnel additions, or product developments will strain cash flow. A company’s working capital can look great on paper, but having the available working capital to scale your business is a whole other challenge to tackle.
What Is the Importance of Working Capital?
The state of your working capital affects the state of your business. Will there be penalties for late payments to your suppliers? What about for your term loan? Traditional business loans have lengthy contracts and fees for missing payments. In order to make these payments, entrepreneurs will get bold. This may mean putting in 70+ hour weeks, turning down new clients because of supply costs, postponing new hires, or even laying off current employees. This is why having the available working capital to cover the costs of doing business is so important.
Working Capital Management Strategies
The main principle of working capital management strategies is that liabilities should not be higher than assets. In addition, having liquid working capital is important for any unforeseen business costs or market changes. If a business cannot afford to keep large amounts of cash in reserve, this is where a working capital financing strategy is necessary. The 3 most common working capital financing strategies rely on a balance of receivables management and financing.
- Conservative Working Capital Management: having more assets than liabilities. This method relies on long-term financing like a loan or line of credit, but lacks liquidity
- Aggressive Working Capital Management: assets are barely above liabilities. This method leaves no room for error or variation in business
- Matching: tries to balance financing with asset type. Inventory is typically kept to a minimum and discounts are offered to debtors for early payment on invoices
Working Capital Financing Strategies
Traditional bank loans are a favorite method of working capital funding. The downsides of bank loans include: application process, length of time before funding, amount of funding, strict requirements for funding. The financing shortfalls from insufficient loans amounts or bank loan rejections opened the business funding space to alternative lenders. This means short term online loans gained popularity for their speed of funding but come at the cost of high interest rates. Merchant cash advances have easy approvals, but the repayment cost is typically astronomical compared to other working capital financing methods. Invoice factoring specializes in flexible working capital financing. Accounts receivable funding refers to the sale of invoices at a discount to a factoring company. This fast financing method eliminates the gap in available working capital between sale and client payment.
