What Is Working Capital?

There’s a formula for calculating working capital. Take current assets and subtract them from your current liabilities. To calculate your company’s working capital ratio or current ratio, take current assets, and divide them by the current liabilities. The ratio gives you an idea of how to cover short term debts with current assets.

Working Capital Formula:

1. Figure out your current assets (i.e., what your company owns).
2. Figure out your current liabilities (i.e., what your company owes).
3. Take your total current assets and subtract them from your total current liabilities.

The number you’re left with is your working capital.

Remember, this is the amount of money you have to work with to grow your business.

Working Capital Ratio Formula:

1. Figure out your current assets (i.e., what your company owns).
2. Figure out your current liabilities (i.e., what your company owes).
3. Take your total current assets and divide it by your total current liabilities.

The number you're left with is your working capital ratio.

Remember, this is the ratio of current assets found on a company’s balance sheet (i.e., cash, accounts receivable, inventory, and other assets expected to be liquidated or turned into cash in less than a year) divided by the current debts on its balance sheet (i.e., accounts payable, wages, taxes payable, and the current amount of long-term debt).

Tip: Measure your company’s working capital ratio every quarter to determine if your company’s cash flow is improving or declining. You want it growing, not falling.

Business owners need working capital because, without it, they won’t have the cash-on-hand to fund their short-term business expenses and growth.

Examples of Short-Term Business Expenses:

• Accounts payable
• Taxes payable
• The current amount necessary to pay down long-term debts
• Payroll
• Rent
• Supplies
• Other overhead costs

Examples of Short-Term Business Growth:

• Opening more franchised units
• Hiring more people
• Creating new products

Working capital is the life force of your business. Over 80% of businesses fail due to a lack of working capital.

There are several ways to acquire working capital for your business. Here are some of the more common ways to get working capital, plus the pros and cons of each.

Save Into a Working Capital Savings Account

As your company generates profits, it is recommended that you save some money back out of your business bank account and allocate it to a specially earmarked working capital savings account. Maintain enough capital to pay all your business expenses for a period of one year; any amount over this amount can be used to help grow your business.

Pros:

• Borrow less money, meaning less interest to repay
• Have enough capital to repay short-term debts
• Build business credit easier — creditors like cashflow rich borrowers
• Weather economic storms (e.g., recessions, etc.)

Cons:

• May impede growth opportunities (saved money might be better invested in growing the business)
• Might discourage business owners form building business credit
• Might take on more debt in the process of saving into this account

Get a Working Capital Loan

A working capital loan is a small business loan granted by a bank. The money is given to businesses with a good credit rating and healthy financials. Your business will need to know how to build business credit to qualify.

Pros:

• Better interest rates than credit cards
• Build credit with your bank
• Revolving credit line
• Borrow and pay back just what you need
• Borrow more money when you need it without a new application
• Short-term loans
• Easier to qualify for than a traditional bank loan

Cons:

• Need excellent credit to qualify
• May need a high personal credit score to qualify
• No partial repayment plans
• Higher interest rates than long term loans

Apply for Business Credit Cards

Business credit cards are useful for maintaining the corporate veil, building business credit, and ensuring your business has the power to cover necessary business expenditures.

Pros:

• Keep business and personal expenses separate
• Useful in a pinch (e.g., if you need to replace equipment that fails, etc.)
• A revolving credit line (i.e., only pay interest on what you spend)
• Various incentives (e.g., airline miles, cash back, points, insurance coverage, etc.)
• Convenient online statements that are easy to hand off to your accountant

Cons:

• High-interest rates and fees
• Requires a hard pull of your credit report, which likely will lower your credit score
• Extremely risky if you can’t repay
• May need a high personal credit score to qualify

Get a Small Business Association 7(a) Loan

The Small Business Association (SBA) is a great resource for startup businesses. The organization helps small businesses get loans through SBA lenders.

Pros:

• Long term loans to help businesses get established and grow over time
• Better interest rates
• Easier to get than traditional bank loans

Cons:

• Long application process
• Must meet certain requirements (i.e., operate for-profit; be engaged in, or propose to do business in, the U.S. or its territories; have reasonable owner equity to invest; use alternative financial resources, including personal assets, before seeking financial assistance)

Businesses need working capital to fund short term expenses and growth opportunities. Most businesses fail because they poorly manage their cash flow.

There are solutions to acquiring the working capital necessary to manage cash flow adequately. These solutions are saving and loans. Acquiring working capital begins with establishing good business credit, then leveraging that debt to build your business.