A business runs on money; you cannot operate without it. Working capital is the fluid, available cash that your business uses to meet payroll, buy supplies and pay for any other day-to-day operating expenses. The net working capital takes into account the many inevitable liabilities that cut into your available capital such as accounts payable or short-term loans. When you pay off your loans and pay your bills, you no longer have those funds available, so your business has less fluid capital to use and spend. Therefore, net working capital measures the short-term liquidity of a business.
Why Is Working Capital Important?
Working capital isn't just important; it's vital for running your business effectively. It's a lifeline that gives you the resources to pay your rent, stock inventory and write payroll checks. However you get your working capital, it should be available when you need it so you can pay your suppliers and take advantage of opportunities.
With adequate working capital, you can meet financial obligations and keep your business afloat. Without sufficient funds to operate optimally, your business can lose money by being understaffed and understocked, forcing your customers to turn elsewhere to get what they need. If you're proactive about finding working capital, you'll save money. Otherwise, if you don't shop around, or run out of options for working capital, you may have to pay exorbitant interest rates on credit cards.
In addition to the day-to-day costs your company must cover, you'll almost certainly encounter opportunities that are hard to pass up, and many will require money up front. For example, your manufacturing business might be offered a large and lucrative contract with a tight timeline. Or a vendor may contact you with a great price on an overstocked item that you regularly use; the only catch – you need to pay for it right away. Having extra money on hand allows you to seize the moment and improve your bottom line.
Unexpected costs can also take the form of emergencies. For a restaurant owner, these may come as broken refrigeration equipment or a flooded dining room. For a delivery business, a vehicle with a blown engine can cost you new business and even existing, long-term customers. Having working capital on hand for the unexpected – known as a contingency fund – allows you to avoid business interruptions or to at least keep these shutdowns as short as possible.
Sources of Working Capital
The ideal source of working capital is from your ongoing operations. If you earn enough to cover daily costs, you won't need to run up debt. You'll save the headaches of evaluating terms and paying interest, and you'll have the money you need on hand when you need it. It's easiest to use operations for working capital if your business mostly runs on a cash basis, such as a retail store or restaurant. Cash sales or receiving payment immediately, allows you to recycle the funds right away to cover ongoing costs.
If your company offers payment terms to customers, it's ideal to keep these turnaround times as short as possible so that the money is available to finance current obligations. For example, instead of 30 days net, you might consider setting your terms to 15 days. If your business is profitable enough over time, you may eventually manage to get ahead of your cash flow with effective cash management strategies. This will allow you to accumulate a surplus of cash you can use for operating capital in the future. Your profitability will not only depend on a strong business model but also on a realistic cash management plan that you can stick to.
If your sales and expenses are not consistent and vary throughout the year, it can be a challenge to finance your working capital. You may need to build up your inventory and pay for advertising for your busy season when sales are slowest, and you're already operating at a loss. Unless you prepare well in advance for the upcoming surge in sales, you won't be able to earn revenue and improve your cash flow situation. Variable sales volume is one reason among many for using external funds for working capital.
Business lines of credit and business credit cards are simple and effective ways to finance short-term working capital. Both are forms of revolving credit or funds that become available for you to borrow again once you have repaid them. With simple applications that don't have excessive documentation or require business plans, lines of credit and credit cards are straightforward to secure and usually, do not require collateral. A line of credit will be linked directly to your business bank account, so you can easily transfer funds back and forth. You can use it for anything from paying rent and payroll to making payments on credit cards or term loans. Credit cards are more commonly used for bills and purchases. Their rates tend to be higher than rates on business credit lines.
Selling business assets is another way to secure working capital. If you have equipment you don't use, or if you need the money more than you need the equipment, selling these items is usually a painless way to obtain additional funds. However, selling assets to obtain working capital isn't an effective ongoing strategy because once you've sold these items, you won't be able to sell them again. If you need to unload something as soon as possible, you're more likely to sell it to the first person to offer – at a bargain-basement price. It's best to sell business assets when you have enough time to find a buyer who will pay a fair price.
Improving Operating Capital
How can working capital be improved? Your business should evaluate as many options as possible, ideally before you need the money. It takes time to secure funding and the better you plan, the more time you'll have to gather information and evaluate rates and terms.
A cash flow pro forma is an important part of the process of evaluating working capital. This is a spreadsheet that shows how much you can expect to earn and spend during an upcoming period, broken down month-by-month. You don't have a crystal ball to foresee what expenses you'll incur during this time frame, but you can make your best guess based on past patterns. Also, keep in mind any anticipated developments such as opening a new location or introducing a new product to the market. You can even create multiple versions of your cash flow pro forma showing best, middle and worst case scenarios.
To create a cash flow pro forma that charts net working capital, list all your anticipated sources of working capital including wholesale and retail sales, income from interest, the sale of property or equipment and rent on property or equipment you own. Reserve the top line of the list for cash on hand since this is an important source of working capital, as well. Below the sources of working capital, list all your anticipated expenditures including rent, materials, payroll, supplies, principal and interest payments, office expenses, insurance, car repairs and anything else that will require your business to spend money.
Format your cash flow pro forma first to add all your sources of incoming capital and separately add all your outgoing cash. Month-by-month, subtract the total expenses from the total revenue and use this net figure as the starting working capital amount for the next month. Your pro forma may indicate that your cash flow projections will leave you in the red, and without adequate operating capital. But don't panic or give up; tinker with the variables to explore ways you can make ends meet. For example, see how things look if you lower your payroll costs by becoming more efficient, or trim material costs by being less wasteful. Once you see the results that cutting costs could make in your cash flow, you can make the necessary changes.
Net Working Capital Versus Net Profit
Net working capital is not the same as net profit or bottom line, but there is some correlation between the two. The more your business earns, the more cash it will have available for day-to-day activities. However, there are times when your business is earning money but is desperately short of cash. On the other hand, there are times when you operate at a loss, but still, you have money to spend.
Net profit is calculated using formulas and conventions that ultimately play out in your company's annual federal tax form. You can only include expenses that the Internal Revenue Service deems deductible, such as only 50 percent of the meals and entertainment you purchase in connection with your business activities. You pay the full price of the meal or the show, but you can only deduct half of it as a business expense. Similarly, big-ticket items such as freezers for your restaurant, for instance, and computers for your office require cash payments up front, but the IRS requires that you depreciate them, or claim only a fraction of the purchase price as an expense during each year that your business used the item.
In contrast, net operating capital focuses on the flow of cash rather than the figures you get after applying accounting principles. It's practical, hard science; how are you going to pay your bills? The accrual method of accounting lists a sale as income when the product and invoice change hands, even though you may not get paid for your work for a month or two. The cash method of accounting will give you a clearer idea of available working capital because it lists income and expenditures at the time they are paid rather than when you deliver the goods.
Loan payments are another area where net income differs from net working capital. If you take out a loan to cover operating costs, you use the money for purchases that appear on your profit and loss statement as current expenses. If you take out a loan for bigger-ticket items that will be depreciated, your profit and loss will break down these purchases and show them spread out over time.
A cash flow statement tracking your net operating capital will treat your loan amount as working capital when you receive it. It will also show your loan payments as outgoing cash as you make the payments. The principal on these payments won't appear on your profit and loss statement because you had already claimed them as expenses when you originally borrowed and spent it. Interest payment entries, however, are part of both profit and loss and operating capital calculations. They represent funds that flow out of your bank account, and they are also legitimate, deductible business expenses.
Both profit and loss and cash flow provide important perspectives on your company's financial picture. Together they help you understand how you earn and spend your money, and how you save and manage it.
Devra Gartenstein founded her first food business in 1987. In 2013 she transformed her most recent venture, a farmers market concession and catering company, into a worker-owned cooperative. She does one-on-one mentoring and consulting focused on entrepreneurship and practical business skills.