When you start earning, you want to make a living, do some savings and also give yourself a better lifestyle. Handling finances can be tough, be it business or personal. Whatever you earn, you prefer to block some of your money in financial instruments like fixed deposits. Why is not all the money blocked? Because some liquid cash is always needed for everyday expenses and unforeseen emergencies. Similarly, in businesses, there are different types of capitals serving different purposes. Read on to know more about working capital.
Defining working capital
As an entrepreneur, working capital for you in the simplest terms is the money you have available for your business. It is the cash you have disposable to carry out your business operations. This capital can be derived from anything, be it your own savings, a loan you took, or the profit you earned.
Working capital can be easily used for conducting everyday business operations like paying rent, giving salaries to your staff, paying creditors, monthly recurring bills. It is also known as operating liquidity.
Evaluating the working capital of a business
Working capital is the difference between your company’s current assets and liabilities. Current assets are cash and other assets from which you can convert immediately to get capital. Inventory, short term investments and amount receivable from debtors are also examples of current assets. Current liabilities are payments and debts that are needed to be settled in a year. Accounts payables, sales tax, payroll expenses, sales tax and everyday wages are examples of current liabilities. If the current assets of your business are more than the current liabilities, your working capital is sufficient and there is no sign of worry there. However, if the current assets are less than the current liabilities, there is a working capital deficit. This is an indication of financial trouble in business and may need your attention.
Working Capital helps you to know the everyday expenses of your business and for how long the business can keep running smoothly based on the liquidly available. The financial experts of any business usually monitor that along with several other business parameters to understand the financial standing of your business. There are several profitable businesses that struggle in generating working capital. Their funds are blocked and even though the business is making money, there is an inability in generating liquid capital.
If you do the math, working capital is simply current assets divided by current liabilities.
Understanding working capital ratio
If you do the math, working capital is simply current assets divided by current liabilities. The answer you receive, the ratio you get how do you know it is healthy or not? If your ratio is anything less than one, it is considered as negative working capital. On the contrary, anything above two isn’t any good either as this means that you have too much liquid cash lying ideal and can be used or invested in better purposes.
So, the perfect ratio is anything between 1.2 to 2. This is usually sufficient as it means that the company has more current assets than current liabilities. Also, the current assets are not way too much that their potential is being wasted.
Companies should also track an overall progression of working capital. If the ratio is getting better and better, the business is functioning more and more efficiently. If the ratio seemed to have denied overtime, there is an underlying problem there and it needs to be addressed immediately.
When is working capital needed?
There are several scenarios where you would need working capital for your business. They can be broadly divided into two categories –
Keep the business functioning
Even if your business is making money or not, there are some expenses that will be incurred and need to be paid be it salaries, rent or electricity bills. Even if your business has slowed down due to unforeseen circumstances like the coronavirus pandemic, some expenses will still need to be taken care of. During such situations where enough funds are not coming in, working capital can be put into great use.
For expansion and growth
Suppose you run a restaurant, if you are planning to expand it, there will be capital needed even post initial stages. As the business expands, the people involved in the business increases too. There will be new short term expenses incurred. The business being in an expansion state the new unit may not produce enough revenue, but the everyday expenses would still continue.
How to generate working capital?
Depending upon the type of business and its scale there can be several ways to generate working capital. Some of the ways to generate working capital and have a growing working capital ratio for most businesses would be –
Requesting an upfront deposit
Sometimes in business when there is a lack of liquidity, a project needs to be halted. One way to cope with this is to ask for an upfront deposit from debtors. Deposits help in minimising the cash crunch that is created due to delayed payments or even no payments at times. When you are asking for an upfront deposit from your clients or debtors, look into whom you are asking to give deposits. For long-term clients with whom you have a trustworthy relationship, deposits may not be required. It is for those clients with whom you have just started dealing and as time goes, the deposit can be waived off.
Consider taking a loan
If your business is currently in a state where the working capital will be needed for the long haul, taking a loan from the bank is a good option to consider. There are several banks that offer loans for small businesses and SMEs. Ensure that your credit score is good so you can negotiate the interest rate on your loans. Taking a loan of a sufficient amount is a great way to build a safety-net for meeting everyday business expenses with ease.
Having a steady and stable working capital takes stress off the back and smoothens the everyday functioning of your business.
Speeding up the collection process
One of the common reasons why the deficit in working capital is caused is due to delay in the payments received by clients and debtors. The conversion time increases and also the current asset is received later on. The tied-up money could have been used for conducting business operations.
Suppose you sell beauty products to parlours, the cycle for paying the wholesalers is 30 days but you collect money from your clients in 90 days. This means you have to wait 60 more days to get your money back. You need to focus on reducing this cycle as it will help in generating working capital more quickly. Start by tracking the time your clients take to make your payments. You can consider negotiating with them about it and also digitalise the process if it isn’t already, to speed up the procedure. Also, provide benefits to clients who make payment early by giving them a small discount. Consider charging late fees for payments that have been delayed for way more than the stipulated time.
You can opt for a peer-to-peer loan if the bank loan interest rate seems too high. Several institutions online and offline offer peer-to-peer loans with no middlemen involved. Since these platforms connect you directly with the lender, the rates are affordable. These loans are quite easy to get but you need to ensure that your profile is low-risk or no-risk. Also, if your money is blocked and you need funds urgently, invoice financing is also an option worth considering. Here you sell unpaid invoices to a third party for generating cash immediately. You have to pay interest for the money you get but usually, it is quite low.
Mistakes to watch out for while generating working capital
Working capital is vital for the smooth functioning of your everyday business activities. There are several mistakes one can make while being focused on generating working capital. One of the biggest mistakes to avoid is taking too many loans or overextending the line of credits. Only get the line of credit or loan that you need and avoid going overboard even if you are eligible for it. Whether it is any loans or lenders you are taking money from, you need to look for hidden fees. Some institutions may have low interest but have hidden charges which you may find about later and regret. Also, avoid using the revenue you receive from old customers to finance the new ones. Doing this often is bound to block the cash flow.
Working capital for any small business or SME is easy to generate if well-calculated and well-planned. Calculate the ratio and see how current assets can be increased or current liabilities can be reduced. Choose the right options for funding your business. Having a steady and stable working capital takes stress off the back and smoothens the everyday functioning of your business. A business is like a rollercoaster ride full of ups and downs, invest wisely during the ups to survive the downs with ease.