How To Calculate Working Capital For Your Business
For any business, working capital is a crucial and difficult financial concept to understand. Working capital, by definition, is the difference between current assets and current liabilities.
Working Capital = Current Assets – Current Liabilities
Current assets are those assets which can be easily converted to cash in a year or within a business cycle. This includes cash, inventories, short-term prepaid expenses, and accounts receivables.
Current liabilities are those entities of a business which have to be paid off within a year or in one business cycle. This includes accrued liabilities, accrued income tax, dividends, and accounts payables.
However, just the formula will not be of much help every time you wish to calculate working capital and the ways to acquire it.
Another tool which is vital for determining working capital is your business’ operational cycle. The operational cycle scrutinises the inventory, accounts receivables, and payables cycles based on the number of days. To sum up, accounts receivables are analysed by the average number taken to collect the amount from an account.
The average number of days it takes to turn over the sale of a product is analysed in the case of inventory, whereas the average number of days it takes to pay a supplier invoice analyses accounts receivables.
However, accounts payable financing isn’t enough for most businesses to finance the operational cycle (inventory days + accounts receivable days). Hence, businesses require financing working capital. Typically, a business covers this either by borrowing funds externally or by the net profits which are generated internally. Some organisations also prefer using a combination of these two modes to finance their working capital.
Listed down are the five common sources of financing short-term working capital.
Businesses must maintain good relations with their trade creditors as they can assist in providing short-term working capital. Having made timely payments in the past helps in establishing a healthy relationship with trade creditors who might be willing to extend the payment terms in time of big orders. At times, the trade creditor would ask for proof of the order as a security, but it shouldn’t be much of a concern as it will give you the much-needed extension of the payments.
Businesses which are fairly new and haven’t been able to generate profit yet can opt for equity funds as an option to fulfil their short-term working capital requirements. These funds can be generated either from your own resources, family members, or third-party investors.
Invoice financing is an amazing option to acquire working capital for new businesses. There are two components of invoice financing – invoice factoring and invoice discounting. These invoices are the account receivables which are lying idle in the books of a company.
Types Of Invoice Financing
There are two forms of short-term invoice financing models – Invoice Factoring and Invoice Discounting
How Is Invoice Discounting Different From Invoice Factoring?
|Point Of Differentiation||Invoice Discounting||Invoice Factoring|
|Recourse||The buyer not necessarily gets recourse.||The recourse will have to be on the buyer.|
|Control of sales ledger||The control of the sales ledger of the business is with the company.||The company providing the invoice financing services has the control of the sales ledger of the business.|
|Confidentiality||It is a confidential service where only the customer whose invoice is discounted is aware of the service being availed.||The customers are aware of the service as the service provider collects payments on behalf of the business which is availing the service.|
|Usage||The number and size of the invoices can differ according to the will of the business.||It is useful only for a one-off single invoice.|
Line Of Credit
Banks usually don’t provide a line of credit facility to new businesses. In case a business is well-capitalised, the chance of getting lines of credit is more. A line of credit enables businesses to borrow funds to fulfil short-term requirements.
Since some businesses don’t qualify for a line of credit, they have the option of taking a one – time short-term loan to finance their working capital requirements. If a business maintains a good relationship with banks, it becomes easier for the business to acquire a short-term loan.
It is clear that working capital plays a crucial role in the success of a business. Entrepreneurs must realise that “Cash Is King”, and they need to understand the value it holds. Hence, a good comprehension of working capital is imperative for the running of any successful business.