Working capital refers to the money available to a company for day-to-day operations. It’s a common measure of a company’s overall financial health. Without adequate cash on hand to provide services or products to customers, businesses struggle to survive and many close their doors.
To improve their cash flow and build working capital quickly without incurring debt, many business owners factor their invoices. Before exploring how invoice factoring as an easy and affordable source of working capital financing, here are some frequently asked questions about this important key to success.
What is working capital?
The definition of working capital is the funds used by a company in its regular operations. Working capital is part of your operating capital, along with your inventory, equipment, buildings, and other fixed assets. You need to know three values to determine working capital:
- current asset: accounts receivable
- current asset: inventory
- current liability: accounts payable
The formula for working capital is current assets minus current liabilities. When calculating your current assets, you need to add up your company’s cash, marketable securities, accounts receivable and inventory that you currently own. To calculate your current liabilities, you need to add up your accounts payable, accrued expenses, notes payable and current long-term debt.
Using the working capital formula and the balance sheet of these two sums, you can calculate your company’s working capital. If the value of your current assets is lower than the value of your current liability, you have a working capital deficiency (or working capital deficit). Even if your company is showing a profit and even if it has substantial assets, if all of these assets cannot be readily converted into cash for operations, your company is threatened by inadequate liquidity. This is when factoring your invoices can make sense to increase your company’s cash flow and liquidity.
What is the working capital formula?
The working capital formula is perhaps the most basic and most telling piece of accounting information that you can have about a company. The working capital formula has been used since the beginning of business transactions.
Working Capital = Current Assets – Current Liabilities
With this formula, you can see your short-term assets that will remain after your short-term bills have been paid. This measure of your company’s liquid assets helps you better predict your company’s chances of success and manage your cash flow.
Adequate working capital and sufficient cash flow are critical even for companies with hundreds of millions of dollars in fixed assets. A lack of working capital can result in more borrowing and more debts to pay off, missed tax deadlines, delayed paychecks, late payments to suppliers and creditors, and more. Late payments result lower credit ratings, adding to the challenges of closing bank loans for more working capital.
On the other hand, business owners can quickly access working capital financing by factoring their invoices as factoring companies do not turn away clients with poor credit histories. Instead factoring companies look at the credit ratings of a potential client’s customers. Factoring also enables clients to smoothly keep up with payroll and taxes and send out their payments on time.
What does net working capital mean?
Working capital can be measured in two different ways. Gross working capital includes all of a company’s current assets – cash, accounts receivable, inventory, short-term investments, and other assets – but does not take into account current liabilities. For instance, you may have received a loan from your bank for $150,000 for launching a new product line and you may have that money in your account, but the gross working capital figure will not show that $150,000 debt that your company owes.
On the other hand, net working capital provides a much more accurate picture of your company’s financial status. Net working capital takes into account those liabilities, or what you owe for employee wages, loan payments, taxes, suppliers’ bills, and so forth. That hypothetical $150,000 addition to your bank account does not increase your working capital. That’s because it is also a current liability and part of your accounts payable.
How do you calculate net working capital?
Net working capital gives you a more accurate guide of where you stand with your cash flow. To calculate this dollar amount, subtract your current liabilities from your current assets. The remainder indicates how much money you have for daily operations. Business owners who are vigilant about calculating their net working capital on a regular basis will have the ability to pinpoint their financial weaknesses and strengths and plan more effectively.
What is working capital ratio?
Once you have added all your current assets and current liabilities to determine your working capital, you can next calculate your working capital ratio. This figure will help show if your company has enough current assets for operating expenses.
Working Capital Ratio = Current Assets / Current Liabilities
When you divide your company’s liabilities into its assets, you’ll come up with a figure showing the relationship between what you have in cash and receivable and what you have to pay out for bills. Many business people consider a 2 to 1 (or 2:1) relationship to be ideal. With twice as much in assets as liabilities, a company can plan and take advantage of opportunities that arise.
Some businesses with seasonal swings throughout a year, in which revenues are down, often strive for a slightly higher asset balance to see them through the slower months.
Companies can work to increase their working capital ratios by changing their payment terms, both in when they receive payment from customers and when they agree to send out their own payments. However, these changes can jeopardize business relationships and can lose both customers and vendors. Factoring eliminates those risks: you will get paid upfront for work you’ve completed, regardless of who long it takes for a customer to pay.
Does working capital equal cash?
While the working capital formula may seem simple and straightforward, some business owners don’t use it regularly. Even if you only use the working capital calculation on a monthly or quarterly basis, you will get a big picture perspective of your company’s financial prospects. However, it won’t necessarily give you insights to how much money you need to achieve your business goals. Working capital does not equal cash exactly, as working capital is also a function of cash flow and operating cycles.
One useful way to figure out how much working capital you need is to analyze your operating cycle, which takes your accounts receivable, inventory and accounts payable cycles into consideration. So instead of simply calculating what your business owns and what your liabilities are, you can take a closer look at the average number of weeks or days that it takes your clients to pay their invoices.
Many business owners find that they can’t adequately meet their operating costs when they look at their operating cycle equation. They clearly see how long they are waiting for clients to pay invoices. It’s not uncommon to wait 30, 60 or even 90 days to receive payment, but this can put unnecessary strain on your company, prevent you from pursuing new customers and profitable projects and affect your ability to meet your monthly expenses. The result: working capital financing is needed to cover the shortfall. Invoice factoring closes that shortfall gap in funding by advancing businesses the money they need for operations and growth.
How should working capital be financed?
Many businesses across all industries will need working capital financing at one point or another, whether it’s to cover the accumulation of inventory over the holiday period or to make it through a few exceptionally busy months.
Many of those companies maintain a healthy working capital ratio by factoring their accounts receivable. Once you’ve completed a job or an order, the factoring company will forward you a large portion of the invoice amount. The factoring company will then handle the collections process for you and pay you the rest of the money, minus a small factoring fee, once your customer has paid the invoice in full.
Through this time-proven method of working capital financing, companies have debt-free funds for the present – and for the future. For more information about improving your working capital with Interstate Capital, a leader in factoring since 1993, get started today with a free cash flow consultation.
For more information about improving your working capital with Interstate Capital, get started today with a free cash flow consultation.