Working Capital Financing: How to Find Working Capital
For a business, working capital is like a person’s temperature, blood pressure, weight, and other health indicators.
InvestingAnswers.com says working capital represents a measure of a company’s liquidity, efficiency, and overall health. In some cases, working capital financing—such as a loan or line of credit—might be needed to inject some life into your business.
How to Find Working Capital on a Balance Sheet
Finding working capital on a balance sheet requires a little math involving the current assets and current liabilities of your business.
Current assets are cash and other company assets that will be turning to cash within one year from the date shown on the balance sheet, according to AccountingCoach.com. Meanwhile, current liabilities are obligations that are due within one year of the date of a company’s balance sheet and will require the use of a current asset or will produce another current liability.
To come up with the amount of total working capital, you subtract current liabilities from current assets. For example:
If a company’s balance sheet dated April 30th shows current assets of $210,000 and current liabilities of $60,000, its working capital would be $150,000. Therefore, $150,000 represents the sum available to finance day-to-day operations of the business.
$210,000 – $60,000 = $150,000
How to Determine if Your Business Needs Working Capital Financing
To figure out whether your business might need to finance working capital, divide the current assets by current liabilities, Citizens Bank says. This ratio helps you determine how much working capital is available to meet the short-term financial obligations of your business.
A “general rule of thumb” is that a business should maintain a current ratio of 2.0. A ratio below that level may signal an inability to adequately cover current financial obligations, while a ratio above that level might indicate that working capital is being used poorly.
Using the earlier example, you divide $210,000 (current assets) by $60,000 (current liabilities) to arrive at the current ratio (3.5).
$210,000 $60,000 = 3.5
Working capital requirements can vary from industry to industry, so working capital for a flower shop shouldn’t be compared with working capital for a law firm.
“Due to differences in businesses and the fact that working capital is not a ratio but an absolute amount, it is difficult to predict what the ideal amount of working capital would be for your business,” Citizens Bank says.
Given that cautionary note, the working capital ratio should be used as an indicator, not a compass. Before making a decision about how to finance working capital, you should consult an accountant, a banker, or another trusted professional who’s familiar with working capital.
Working Capital Financing Options
Working capital financing does not come in just one form. Here are seven types of working capital financing that might be available to you and your business.
Business Line of Credit
A business line of credit lets you draw money against a set credit limit as needed, rather than getting the entire loan amount all at once, according to FitSmallBusiness.com. In that way, it’s similar to a credit card.
“The advantage of a business credit line is that you only pay interest on the funds you actually draw. That means you’re not stuck paying interest on capital you don’t have an immediate use for,” FitSmallBusiness.com says.
A business line of credit can be continually renewed, or you can allow the line of credit to lapse once you’ve paid off the balance. This is often considered the most attractive and affordable option for working capital financing
Short-Term Business Loans
A short-term business loan enables a business to borrow a set amount of money—$100,000, for example—that’s paid back over a scheduled period, according to the QuickBooks blog. Most short-term business loans are meant to be taken out and paid off in less than a year.
“While larger banks provide most of the traditional loans in this country, entrepreneurs can secure short-term loans through smaller banks and lenders like credit unions. As a result, the lending criteria for short-term loans tend to be less stringent,” the QuickBooks blog says.
As with a traditional longer-term loan, a short-term loan requires the borrower to pay back the principal and interest. While short-term business loans often are easier to get than traditional small business loans, it’s important to keep in mind that short-term business loans usually have higher interest rates than the longer-term alternative.
Working Capital Loans
Unlike a business line of credit or a short-term business loan, a working capital loan might require collateral from both the business and the business owner.
Some working capital loans are unsecured, meaning no collateral is needed. However, those loans typically go only to businesses or business owners with solid credit histories. If a business or business owner has a poor credit history or no credit history at all, collateral likely will be required for what’s known as a secured loan.
The principal and interest on a working capital loan normally are paid over a short period of time, as with a short-term business loan.
Because of the high risk involved in a working capital loan, interest rates usually are higher than the rates for traditional and short-term business loans, Investopedia says. In addition, many working capital loans are tied to the business owner’s personal credit, meaning that missing a payment or defaulting on the loan can hurt the owner’s credit score.
Business Credit Cards
A business credit card gives a business the ability to easily make purchases or get a cash advance. It’s a source of quick financing whenever you need it.
A business credit card is a revolving account (like a business line of credit) that has a set credit limit—$25,000, for example. If the balance is $4,000 and the credit limit is $25,000, then $21,000 would be available for purchases or cash advances.
The amount of money available to a business through a line of credit or a short-term loan tends to be higher than the amount available through a credit card, according to Investopedia.
If the cardholder carries a balance from month to month, interest will be charged. As opposed to a line of credit or a short-term loan, which have fixed interest rates, a business credit card’s interest rate can fluctuate. A credit card usually has a higher interest rate than a line of credit or loan, Investopedia points out.
Accounts Receivable Financing
Businesses frequently deal with customers that pay invoices on a 30-or 60-day cycle.
“Unfortunately, some companies don’t have the cash reserves to wait that long for payment. They need to get paid sooner so that they can pay for their own expenses,” according to Commercial Capital, a business finance company with U.S. headquarters in Miami.
Accounts receivable financing allows a business to obtain early payment on outstanding invoices. With this type of lending, a business commits some or all of its outstanding invoices to a funder as collateral, then receives early payment of the invoices in exchange for a fee.
Three kinds of accounts receivable financing are available: asset-based lending, traditional factoring, and selective receivables finance. All three of these options tend to cost more than a regular bank loan does.
Cash Flow Financing
With cash flow financing, or a cash flow loan, a lender is making a bet on the success of the business that’s borrowing the money. When taking out a cash flow loan, a business is borrowing against the money it anticipates receiving. A lender will extend a cash flow loan based on the past and projected performance of the business.
Because these loans are so risky—cash flow lenders don’t scrutinize borrowers the same way traditional lenders do—borrowers are charged significantly higher interest rates and fees, Accion says. In that regard, they’re similar to payday loans.
Merchant Cash Advances
“Typically, the borrower then pays back this balance—plus a hefty premium—through automatic deductions of their daily credit card or debit card sales or from the business’ bank account,” according to CNNMoney. Borrowers who take out merchant cash advances frequently wind up paying interest rates that are effectively 100 percent or more
It’s important to note that if you decide to take out a merchant cash advance loan, you must be aware that you’ll need to generate at least a 100 percent return on the funding to cover the high costs of the loan.