Working Capital For Small Businesses
As a small business owner, you have to wear many different hats. Some of them are exciting—like building relationships with customers and providing solutions to their problems—while others aren’t (does anyone like doing paperwork?).
When it comes down to it, one of your responsibilities is to make sure your business is in good financial standing. One of the ways you can assess this is by looking at your working capital. What is working capital and how can you leverage it strategically to help your business continue to grow and succeed? We’ll take a deep look in this guide for small businesses.
What Is Working Capital for a Small Business?
Working capital for a small business is a way to measure the liquidity of your assets. This sum of money is what you have available on hand that you can use to pay for daily expenses. Although they are related, working capital is a different metric from profit and revenue. While revenue looks at all the money coming in and profit examines how much is left over, working capital is the sum of all your current assets minus your liabilities. So, what is working capital used for? Essentially, working capital is a way to measure your small business’ short-term financial health.
One complicating factor is that there are different types of working capital. The four main types of working capital are net, gross, permanent, and variable.
Net Working Capital
This is the most common type of working capital. Net working capital refers to the sum of money that equals the total assets minus current liabilities. More on how to calculate net working capital in a moment!
Gross Working Capital
Gross working capital equals the total amount of cash and assets in the business at a specific moment in time. For example, this might include cash, short-term investments, or accounts receivable—any asset that can be converted to cash fairly quickly.
Permanent Working Capital
Also known as“fixed working capital,” this is a way to look at your assets that are tied up. Permanent working capital measures the minimum amount of cash or current assets that you need to cover your small business’ current liabilities. This is divided into regular working capital, like the money you need to run payroll, and reserve margin working capital, your fund for emergencies like inflation or a cyberattack.
Variable Working Capital
Variable working capital is sometimes referred to as flux or temporary working capital. This metric looks at the amount of cash and assets needed to meet temporary or seasonal needs.
What Is a Working Capital Requirement?
Working capital requirement is the amount of money you need on hand to cover all your operating expenses, debts, and production costs during a given period. Think of it like this—there’s a period of time between purchasing and paying for supplies, producing your goods and services, and then receiving payments from customers. The working capital requirement is how much money you need to move from production to payment.
Small Business Working Capital Example
Let’s take a moment and look at an example of profit and working capital. Imagine you run a small business like a bakery. In your second year of business, you find when doing the numbers at the end of the year that you made a profit of $10,000. However, during the summer months, business slowed down drastically due to the heat keeping folks at home, reducing foot traffic to your storefront. During July, you had to make rent, pay your flour supplier, and your employee but had very little working capital due to the summer slump. Luckily, you were able to free up some assets to cover your expenses. In the fall, business picked up rapidly, and you finished out the year strong.
As you can see from this example, it’s clear that profit and working capital both are important metrics to track to understand the short and long-term financial picture of your small business.
How To Calculate Working Capital
Calculating net working capital is fairly simple. First, you need to understand what your assets and liabilities are. There are four main components to look at:
1. Cash and Cash Equivalents (An Asset)
Remember how working capital is primarily a metric of liquidity? Because of this, the best place to start is with cash and cash equivalents. This includes things like:
Cash on hand
Money market accounts
Stocks and bonds
Certificates of deposits
Anything that can be quickly converted to cash
It’s vital to understand your immediate liquidity in case of emergencies or urgent situations (like needing to purchase three more mixers because your bakery business just took off).
2. Accounts Receivable (An Asset)
This component is not as liquid as cash, but is still a valuable asset. Accounts receivable is another way to refer to money that is owed to you but has not come in yet. For example, any unpaid or open invoices, an outstanding line of credit, or accrued interest would all be in this category.
3. Inventory (An Asset)
If your small business sells physical items, you should include this in your calculation of your assets. While you cannot spend this, it is still an aspect of your overall current liquidity. Your inventory can include:
Items on display in a shop or storefront
Items stored in a warehouse
Items already purchased from a supplier that are in transit
4. Accounts Payable (A Liability)
This category is the liability part of working capital. To calculate this, simply add up all of the costs you expect to owe within the next year excluding any long-term payments that are due after a year. This could include things like:
Now that you have a good picture of your current assets and liabilities, you can calculate your working capital. Simply subtract your current liabilities from your current assets. The easy formula is:
Current assets - current liabilities = working capital
For example, if your bakery has $300,000 in assets and $125,000 in liabilities, its working capital is $175,000.
How To Calculate Working Capital Ratio
The working capital ratio is another way to calculate liquidity. To figure this out, divide your current assets by your current liabilities.
Current assets / current liabilities = working capital ratio
Taking the same numbers from the above example ($300,000 of assets, $125,000 of liabilities), your bakery has a working capital ratio of 2.4.
How Much Working Capital Does a Small Business Need?
It’s hard to know how to calculate how much working capital is needed, especially if you’re a small business owner with a lot on your plate. One great place to start is with your working capital ratio. In general, if that number is between 1.5 and 2.0, you probably have the right amount of working capital.
However, this does vary by industry, as well as what phase your business is in. If you’re a seasonal business with a high inventory, like a retail store, you may have a higher ratio during your peak selling time. If you’re a company that provides services, you will probably have a lower working capital ratio. This metric may vary too if your business is in a growth phase. During times of investment in new equipment, bringing employees onboard, or preparing for your busy season, your working capital ratio may be fairly low. As you can see, your working capital may fluctuate. That’s why working capital management is so important.
What Is Working Capital Management?
Working capital management is just what it sounds like—strategies to help you have the full picture of your working capital and make sure that you’re using it as best that you can. You can use metrics like the collection ratio and inventory turnover ratio to help you adjust your business operations to optimize how and when you use your working capital.
Sometimes referred to as the days sales outstanding, this metric is the average estimate of the amount of days it takes a company to receive payment after a credit sale. (Cash sales are received immediately, so those payments are not included in this metric). To calculate the collection ratio, divide the number of outstanding accounts receivable by the total amount of credit sales during the same period. Then, multiply that by the number of days in the period. The formula is:
(Total accounts receivable / total credit sales) X number of days = collection ratio
A higher ratio indicates a lack of working capital, as this means it takes longer to collect payment.
Inventory Turnover Ratio
When you have a physical inventory, it’s important to track how quickly it leaves your facility. This will help you adjust the amount and timing of restocking to avoid purchasing unnecessary products. To calculate your inventory turnover ratio, divide the cost of the goods sold during a set amount of time by the average quantity of inventory. The formula is:
Cost of goods sold / average inventory = inventory turnover ratio
A high ratio can point to a lack of inventory while a low ratio may mean that you have too much inventory. With this metric, it’s important to find the right balance for your small business.
Can You Get a Loan for Working Capital?
Yes, you can. And sometimes, a working capital loan can be the right option for small businesses. However, you do have other options. If you need working capital fast and want to be able to pay it off quickly too, we’re here to help. At Backd, you’ll find short-term financial solutions so you can access working capital quickly and easily. Our merchant advances range from between $10k and $2M.
Many small businesses need support for growth projects, and we love helping you achieve your vision! If your business has
Been in business for at least one year
A personal credit score of at least 600
A minimum annual revenue of at least $300k
At least 10 months of deposits in a business bank account
Backd might be the right choice to help you grow your business.
Backd: Bringing Working Capital To Small Businesses
At Backd, we know how important small businesses are for a strong economy. We want to make it as easy as possible for you to access working capital. You’ll find competitive rates, same-day decisions, a speedy application process, and flexible terms at Backd.
With unique customers, we love providing working capital solutions that are just as vibrant. In fact, more than 3,700 businesses are currently being Backd. Interested in becoming one? Reach out to us today. We’re standing by, ready to help you grow.