What is Working Capital?
Working capital measures a business’ ability to pay its short term liabilities. This is measured by subtracting the total current assets from the total current liabilities. Current assets include cash, inventory, receivables, and other assets which are expected to be turned into cash within one (1) year. Current liabilities include accounts payable, loans of one year or less, and other liabilities which are expected to be paid off within one year. Working capital allows management the opportunity to see what is available for day-to-day operations.
What Does This Mean to a Business?
Having working capital is crucial for any business, as it impacts both the short-term operations and the long-term goals of a business. Being able to pay short term liabilities influences a business’ day-to-day operations. A business has to be able to pay its vendors in a timely fashion. Failure to do so can result in the business not being able to purchase inventory/supplies/services on credit prior to receiving payment from the customer. As a result, cash will need to be paid prior to cash being received.
When it is time to expand the business, a long-term loan will most likely be needed. If a business does not have enough current assets to cover its current liabilities (or worse is unable to cover the current liabilities at all), it will be very difficult for the business to obtain the much needed loan. If the business is able to obtain a long-term loan it will cost more because the business is considered a risky investment. The increased costs of money or the inability to obtain a loan can cause the business to miss out on many great growth opportunities.
What Can A Business Do to Increase Working Capital?
A short-term plan to increase working capital may be to have a line of credit (LOC). A business owner will want to keep this to a minimum. Even though a LOC will provide cash in hand, it is also a liability. Remember working capital is current assets minus current liabilities (cash – LOC = $0). This is essentially robbing Peter to pay Paul. It will only work for the very short-term and should not be the business’ main source of cash. Ideally the business will need to be bringing in enough cash through sales to run without a LOC. There are exceptions to this rule of thumb so be sure to consult your accountant.
Business owners can put their personal money into the business as well. This will improve the difference between current assets and current liabilities because the related party loan will be recorded as a long-term liability. The disadvantage of this to the business owner is that they will have less cash for their personal finances.
A business can replace short-term debt with long-term debt. This can help in the near term, but payments still need to be made on the long-term debt. Be sure to review your plans for covering the long-term debt with your accountant before restructuring the loans.
Long-term Plans to Increase Working Capital
A long-term plan to increase working capital includes setting guidelines for managing short-term debt and daily/weekly/monthly spending. Finding ways to collect on receivables sooner will also be beneficial. The sooner customers pay, the sooner the cash can be put to use. Talk to your accountant about ideas for managing the business’ spending habits and ways to collect on receivables faster.
Receivables can also be collected for less than recorded in order to bring in cash quickly. When selling a product or service, some businesses may offer a discount if paid by a certain date. This encourages customers to pay sooner. Again you will want to consult with your accountant before offering a discount. You will need to decide how much of a discount to offer, how long the discount is available, and whether your business can afford it.
Another long-term plan is to issue more stock, which increases the cash on hand. This will have an impact on the existing shareholders, so be careful. It will mean less profit for the original shareholders because the profit will be divided among more portions. This could lead to some of the original shareholders pulling out as a result and putting the business in a worse position than it was.
Working capital is a must for any business. Managing it is even more critical for the success of the business. There are many ways a business can manage its working capital and it is not a one size fits all world. Before making any decisions, consult with your accountant. Your accountant can help you create strategies that are best for you and your business.
Contributed by Jamie M. Shryock, CPA