Most businesses need working capital at some point, but most businesses go about calculating their needs in some way other than the way that actually matters. The most common way to calculate working capital is to subtract current assets from current liabilities. However, this only gives you a snapshot of your current financial situation.
It tells you nothing about invoices that are outstanding, expenses that are outstanding, and inventory that hasn’t moved yet. What you need is a way to track money through operating cycles. That way, you’ll know what you’ll have at the end of a complete cycle and your financial picture will be much clearer.
Even using operating cycles, though, doesn’t guarantee that you’ll never need working capital. For many small businesses, working capital comes from net profits (cash reserves) of the company. But not all companies have access to enough cash. For cash-starved businesses, there’s several important ways to raise the funds needed:
Equity is basically personal savings. If you’ve got personal savings, or a family member is willing to infuse your business with cash, then this may be the cheapest source of working capital you’ll find. This is also, paradoxically, the hardest to acquire since it basically means you need to have savings already built up.
Factoring is another way for small businesses to get short-term working capital. With this type of arrangement, you sell your accounts receivable to a factoring company. They typically pay you a fraction of what those invoices are worth, plus a processing fee. They then take on the responsibility of collecting on those invoices. While most factoring companies are easy to work with, it’s going to cost you a lot of money to factor in the sense that you may only receive 85 percent of the value of your accounts receivable.
If you have good relationships with your trade creditors, you might be able to work out a deal with them for short-term financing. If you’ve paid on-time in the past, a trade creditor might be willing to extend terms to allow you to meet a larger order. So, let’s say you’ve received a large order that you can fulfill within 60 days. You may be able to obtain 60-day terms from your supplier if 30-day terms are normally what’s given to you. Now, your trade creditor will want proof that you actually do have an order forthcoming, and the “financing” is actually just sales that you know you’ll get.
A Line of Credit
Getting working capital loans from a bank aren’t always easy, but a line of credit with a bank you have a relationship with will often be enough to get you out of a jam. Of course, you typically already need to have a relationship established for this to work out.
Short-term loans are the hardest to qualify for, especially if you’re a new business. Banks typically want to do business with established companies that have a track record of paying their bills. From the bank’s perspective, new enterprises are risky – often too risky for a banks mostly conservative portfolio. But, if you can secure a loan with a bank you have a good relationship with, go for it.
Jeremy S studies finance. He enjoys blogging about money management and small businesses.