One of the key reasons many small businesses apply for loans or other forms of financing – including Merchant Advances – is to supplement their working capital. This value is critical in assessing the financial performance and stability of any business, and serves as a strong indicator of operational efficiencies. Read on to find out how working capital is measured and what implications it has for your business.
A Capital Idea
Working capital is simply defined as the difference between a company’s current assets and outstanding liabilities. It can also be expressed as a ratio. A ratio value below 1.0 indicates that a company may have trouble covering its outstanding debts in the short term. A value of 1.0 or greater indicates that the company has at least sufficient assets to cover any current debts.
Digging Deeper: Working Capital as Indicator
Though this calculation is relatively simple, it is a valuable indicator of many aspects of general financial health that may belie more complex information than a simple arithmetic like the one shown above.
- Inventory management and cash flow
- One of the most significant uses of working capital is inventory. The longer inventory sits on the shelf or in the warehouse, the longer the company’s working capital is tied up. So, in a sense, too much working capital (a ratio over 2.0 for example) can be undesirable. This is a definite indicator as far as a company’s operating efficiency and liquidity! The Speed of Conversion from inventory to cash is a key metric in this case.
- Payment processing
- If a company has very consistent sales and its customers pay with credit cards at the time they place the order, a small amount of working capital may be sufficient. On the other hand, a company in an industry where the credit terms are net 60 days and its suppliers must be paid in 30 days, the company will need a greater amount of working capital.
- Managing Seasonality
- Most businesses need short-term working capital at some point in their operations. For instance, retailers must find working capital to fund seasonal inventory buildup between September and November for Christmas sales. But even a business that is not seasonal occasionally experiences peak months when orders are unusually high. This creates a need for working capital to fund the resulting inventory and accounts receivable buildup.
- Business Growth
- As a business grows and expands, its need for working capital changes as a percentage of its sales. If your turnover increases by a certain amount, you may need extra working capital to fund this growth especially without jeopardizing the stability of your cash flow.
Does your small business need assistance obtaining working capital to assist with one of these key management tasks? Visit us at Merchant Advance Capital to find out how we may be able to help.