Working Capital: Why It's Essential For Small Business Growth

Every business, whether startups or blue chips, must learn to properly manage their working capital to ensure financial health and improve daily business operations. It’s key to unlocking the business to growth opportunities. It’s imperative, therefore, that you should determine how much your business needs and how to effectively manage it. 

Working capital may mean a lot of different things to different business owners, depending on the industry and the management style.

But how does working capital help for small business growth? Before we delve into that, let’s first have an understanding of the fundamentals of working capital. In that way, you’ll eventually learn why it matters to your business. 

What is Working Capital

Often abbreviated as WC, working capital refers to the difference between a business’ current assets and its current liabilities as reflected on the balance sheet. Primarily, current assets pertain to anything that an entrepreneur can convert into cash within the next 12 months. On the other hand, liabilities are the expenditures a business incurs within that same duration. 

Among the examples of current assets are accounts receivable, prepaid expenses, cash, inventory, cash equivalents, and marketable securities. Current liabilities, on the contrary, include accounts payable, income tax payable, wages payable, interest payable, and customer deposits. 

Working capital fundamentally reflects the current short-term financial health. That means it indicates whether a business has sufficient short-term assets to fund day-to-day operations and short-term loans. Although somewhat similar, WC and cash flow are two different things. But both of them provide critical measurements for assessing financial health. 

Working capital provides an overview of the current financial state of the business, while cash flow accounts the ability of a business to generate cash over a specific period. The majority of companies with substantial cash flow will also have substantial working capital. There is, however, some divergence depending on things like investments, paying off old loans, and giving shareholders their rightful dividends. 

Once you determine your current assets and current liabilities, you can then apply the working capital formula, which is: WC = Current Assets – Current Liabilities. 

The results of the calculation between current assets and current liabilities are often referred to as net working capital. 

In many cases, the term “working capital” is misused when referring to the financing needs of a startup business or small business. For instance, if a small business is considering to fund typical operating expenses like an advertising budget and salaries for new employees, what it really needs is “long term capital.” This is also called equity. 

Likewise, if a business is incapable of supporting the costs of advertising and salaries, then it is most likely under-capitalised. If the business is reflecting losses for the first year, it most likely needs equity instead of working capital. Take note. Money used to finance the growth of short term assets like accounts receivables and inventory is better referred to as working capital financing. 

Measuring your Working Capital Needs

In general cases, a business prefers a positive WC ratio (Current Assets/Current Liabilities). In theory, however, a company should be able to meet all of its short-term expenses if it has a working capital ratio of 1.0. For more established entities such as analysts, banks, and accountants, they would prefer to see that number slightly higher. 

Essentially, an excess working capital gives a business a kind of “cash safety net” against sudden changes and unexpected expenses. For example, when a significant typhoon wipes out an entire factory and its adjacent farms, the business can only recover adequately if it has enough cash in store. 

On occasions like that, WC can be reinvested back into the business to fuel its growth. It’s essential, however, to consider that a ratio below 1.0 means that current assets are not enough to meet the short-term debt. That could mean that a business needs to source or generate additional business capital. 

Based on recommendations, healthy working capital should generally fall somewhere between 1.2 and 2.0. That indicates enough short-term liquidity and reliable overall financial health. If the ratio is too high, however, problems could arise. Although not exactly a bad problem, a ratio higher than 2.0 may show that a business is not maximising its excess cash and assets by actively investing them in boosting the business. 

Any available excess cash is technically considered a liability. Such a situation may also indicate poor financial management and missed business opportunities. 

Warren Buffet, arguably the world’s greatest investor, said that cash is a bad investment because it deteriorates in value over time. That also applies to companies holding an enormous amount of money that is not being put to productive use. 

Now, when you have a small business, and it has been running smoothly and experiencing growth, getting a hold of your company’s working capital is an essential aspect of its overall financial health. And while the amount of working capital and the working capital ratio will surely differ from company to company, it is a helpful tool in identifying your business’ profitability. It can even be used to create smart, informed decisions for your business at any stage. 

How Does WC Fuel Small Business Growth

 As mentioned earlier, managing working capital can help you maximise operational efficiency. That, in turn, leads to smooth business operations, helping fuel business growth, especially in terms of earnings and profitability.

Managing working capital includes maintaining the working capital’s operating cycle and ensuring its organised operation. This minimises the cost of money spent on the working capital while maximising the yield on current asset investments. 

Now, there are cases when a company does not have sufficient working capital to fund its obligations, resulting in financial insolvency. It can lead to legal troubles, liquidation of assets, and potential oblivion. This has happened to some of the biggest companies in the world, including industries involved in energy, utility, and banking. 

Who would have thought, for example, that the Lehman Brothers went bankrupt during the 2008 financial crisis? It is one of America’s leading banks and has been around since the 19th century. You could ask a similar question to all the giant companies which perished during the 1929 financial crisis, which led to the Great Depression. 

All these cases prove that no business is immune to drastic economic changes and dangers. There are always turmoils and volatilities. Thus, every company must have adequate management of working capital. 

We need to emphasise that managing working capital is essentially a strategy of accounting with a focus on the maintenance of a substantial balance between a company’s current assets and liabilities. If done correctly, it will not only help businesses cover their financial obligations but also fuel their ability to earn more.

In doing that, you also need to utilise key performance ratios such as the working capital ratio, the inventory turnover ratio, and the collection ratio. All these help determine areas that entail focus to sustain liquidity and profitability. 

How Much Working Capital does your Business Need?

After assessing the current status of your business , it’s essential to identify what information signifies in the context of your daily business operations and future goals. 

Applying the working capital ratio model, if you reach around two, that shows that your working capital is positive and you have cash available for operations and investments. If you score below a one, that means your small business has a negative working capital. What should you do then if that’s the case? 

First, identify what’s causing the situation. It may come as a result of various root causes, from poor marketing to high expenditures. Therefore, devise a plan to spend less, improve marketing, boost sales, or generate an influx of capital into your business. 

Even if you assess that there’s just enough working capital available, it’s imperative to ponder on the following questions to validate if it’s enough:

• Do you anticipate any surge in expenses that could catapult liabilities?
• Are you geared to investments or expansions that entail capital?
• Are you planning for any operational shifts such as a future inventory purchase, that will require a significant amount of capital?

To put things into perspective, let’s consider the story of Cristina, a small business owner. Cristina just found out that while she had sufficient capital available to meet her fundamental obligation, an unexpected spike in demand could slash her cash significantly. Moreover, funding a marketing campaign and investing in new products or services to grow her business was beyond what her current savings could handle. As she pondered on how to get working capital for small business operations, she suddenly realised that there are lending options out there. 

Forbes mentioned that loan opportunities for small business owners had grown significantly in the past year, projecting more options to access working capital loans. Properly borrowing money can provide you with the resources you need to reach your goals. 

Where to get WC for Small Business Operations

Let’s assume that you’ve realised the need to access more working capital. What should you do? Where or from whom should you source short-term operating capital? The following are some standard small business working capital options that you can take advantage of to help meet your short-term obligations:

• Family, Friends, and Relatives. In many cases, small business owners tend to borrow money from family, friends, and relatives to address short-term expenses. There are different factors at play here, but the first two things to consider are risk and relationship. 
• Small Business Working Capital Loans. These loans aim to help small business owners meet short-term needs. They’re available up to a cap of $250 000 even though the amount can vary from $5000 to $500 000. They are usually repaid over a year. Some alternative lenders provide working capital loans that can meet the needs of various types of growing businesses.
• SBA Loans. The SBA offers a loan program, and in typical cases, these loans are used to cover the working capital of a small business. SBA loans, however, undergo traditional lenders that may demand more stringent and strict requirements and guidelines. 
• Business Credit Cards. Though, it varies on how much working capital you need, a business credit card may give you a good option. It’s imperative to assess interest rates with credit cards and how fast you’ll be able to repay the credit. 

Today, more and more small business owners are shifting to strategic lending options. Aside from convenience and more accessible processes, having a little business working capital can help ensure that you successfully hurdle weather storms. Such money can also help you cover your short-term obligations, and are ready to make the most of longer-term investments and opportunities. 

How to Make the Most of Your Loan

Having a small business working capital loan can make it easier for you to hurdle logistical hiccups and keep your business running well. Here are a few steps you can implement to ensure you’re correctly managing your loan: 

• Manage your Business Expenses. Scrutinise your business expenses. Are there areas where you can reduce spending? If yes, now may be a good time to cut spending or engage on less expensive alternatives to what you are currently doing. By cutting expenses, your working capital goes further and can help maintain your daily business operations. 
• Increase in Sales and Revenue Collection. It’s important to keep revenue flowing into your small business. That ensures that you can repay your working capital loan and build a safety net for the future.
• Plan Long-Term Financial Management Tactics. What should you do to improve your long-term financial management? That depends on every business.You should actively engage in long-term planning to sustain a healthy ratio of working capital for your future goals. 

 Conclusion

Having a good amount of working capital enables you to run your business smoothly. It also helps you to invest in and fuel the growth of your small business. Regardless of your goal – whether to achieve an efficient business system or improve marketing to reach more prospective customers – your working capital makes all of your business goals possible. Take the time to assess what your business needs and then collaborate with a funding partner to catapult your business to success.