Working capital is the amount of cash your business has after factoring in your short-term debts. It’s a good way to judge the financial health of your business, and a simple way to assess how you’re performing at any given time.
If your working capital is low, this lack of cash may mean you don’t have the money to invest in growth opportunities. But your working capital can also be too high, which may be a sign that you’re not investing appropriately in your business. Even businesses with large amounts of working capital can face cash flow problems if they struggle to convert their assets into cash.
All small business owners should understand their working capital cycle, which is the period it takes from producing their product or delivering their service through to receiving payment. The longer the cycle, the longer your business has capital tied up in accounts receivable that can’t be used to meet operating costs or invest for growth.
How to calculate your working capital
Your working capital is your current assets (accounts receivable, inventory and cash held) less your current liabilities (accounts payable, payroll, loan repayments, taxes, etc). Your working capital can be calculated by subtracting your current liabilities from your current assets, as follows:
Company A: Has $10,000 of current assets and $8,000 of current liabilities. This gives them a working capital of $2,000.
Company B: Has $8,000 of current assets and $10,000 of current liabilities. This gives them a working capital deficiency of $2,000.
Current assets – current liabilities = working capital
It’s also helpful to have an understanding of your working capital ratio. This can be calculated by dividing your current assets by your current liabilities, which looks like this for the examples above:
Company A: $10,000 / $8,000 = 1.25
Company B: $8,000 / $10,000 = 0.8
Current assets / current liabilities = working capital ratio
Why growth can lead to cash flow problems
Even large established businesses sometimes face into cash flow challenges. Perhaps you’ve needed to replace an expensive piece of equipment unexpectedly, a key customer is late in paying their account, or you need to put down a deposit for a large or custom order.
Ironically, strong growth can be the cause of cash flow problems for many small businesses. If you offer 30 or 60-day credit terms to your customers but your suppliers require payment on delivery or at end of month, your expenses may initially exceed the amount you’re collecting – a situation that could last for weeks, months or longer. More customers and/or more orders are certainly a positive for business growth – but this scenario needs to be managed closely to ensure a temporary gap between incomings and outgoings doesn’t derail your business.
5 way to access additional working capital for your small business
It’s a good idea to have a solid plan to access additional working capital if and when you need it. Today, small business owners have plenty of options when it comes to working capital finance – in fact, it can be difficult to know which one is best for your business. Some popular choices are:
01. Unsecured Business Loan
An unsecured business loan is a short-term facility that gives you access to funds which can be used for any business-related expenses. No security is required which means that interest rates for this type of funding are usually quite high. Most unsecured business loans require repayment within 12 months.
02. Line of Credit
A line of credit works in a similar way to a credit card – you can access funds up to a certain limit and you only pay interest on the amount of money that you use (however fees are usually payable regardless of whether you use the facility). You’ll need to make regular payments and the entire line of credit is repayable on demand.
3. Invoice Finance
Also known as debtor finance, invoice finance allows you to access funding using your accounts receivable ledger as collateral. You can access cash as soon as your client invoices are sent, which makes invoice finance a great option for smoothing cash flow and covering short-term cash shortages.
4. Hire Purchase
Hire purchase can be used to buy plant, machinery and equipment for your business. The asset is owned by the lender until the end of your finance term – at this stage, you can choose to keep, sell or replace it with a brand-new equivalent. Hire purchase can be an attractive way to pay for an expensive piece of business machinery. An upfront deposit is usually required.
5. Personal Loan
If you own the business, you can apply for a personal loan and use these funds to bridge cash flow gaps. Personal loans are flexible – you can pay in instalments throughout the loan term and they can usually be repaid early - but they’re a risky option as you’re personally responsible for the repayments.
While it’s great that Australian small businesses have lots of choice when it comes to accessing additional working capital, assessing the options to understand how well they fit with your business can be overwhelming.
If a lack of working capital is stopping you from reaching your growth aspirations, we offer a free 30-minute strategy session where our cash flow consultants can help you to explore the most suitable funding options for you.
Cashflow Finance has supported Australian small business with flexible invoice finance, trade finance and equipment finance solutions for more than 30 years. Call us today on 1300 760 205.