Working capital is sometimes known as the “lifeblood of a business.” It is not an exaggeration when they say that business, although profitable, will fail if it falls short of cash. Working capital can be defined as the amount by which current assets exceed current liabilities. In other words, it is the amount in current assets you have available for each current liability that you owe. One of the most useful tools to determine the working capital of a business is the operating cycle. Most companies cannot finance the operating cycle of their business with the current assets alone, which means working capital financing is needed. The shortfall that a business has can be covered internally by their net profits or by borrowing funds from an external source, or a combination of both.
Why Do Businesses Need Working Capital?
Most businesses need short-term funds at some point in their operations. For example, a retailer may need some additional funds to build up their seasonal inventory between October to November to stock up for Christmas sales. But even those businesses which are not seasonal also experience peak months when their orders are unusually high, meaning a company needs extra funds to meet the additional demand.
Many businesses already have enough cash reserves from which they can fund their seasonal demand. This is, however, quite rare for a new business. The most important thing is to plan ahead and arrange for the peak time when you will need additional funds. The most common sources of working capital financing are:
For a small or new business, this may come from the owner’s own personal resources or from their friends and family members.
- Trade Creditors
If the business is in good terms with their trade creditors, you may be able to get their help for providing you working capital. They may, however, want proof of your order from your suppliers such as a lien or security.
Once the business has filed an order, the factoring company buys the accounts receivable and handle the process of collecting the funds. This is often used by new businesses and may be more expensive than conventional bank financing.
- Line of Credit
It may be difficult for a new business to qualify for a line of credit by a conventional bank unless they have good collateral and sufficient equity. A line of credit allows the business to borrow funds on “need basis” for a short period of time.
- Short-term Loans
Even if a new business is unable to meet the requirements for a line of credit from a bank, they may be successful in getting a short-term loan (for less than a year). This is a lump sum amount given to the business to meet their shortfalls in cash.
Read more on how working capital can help your business.
Where Should a Business Deploy Their Working Capital?
Once you have access to working capital for your business, you must decide on how to spend that capital in the most strategic way. Many business managers who do not have enough experience with working capital deployment fall into tempting traps of spending the money that can jeopardize the business. To avoid this, it is best to familiarize yourself with the correct ways to use or deploy your working capital into the business.
Most of the new businesses have specific priorities on which they want to focus on, while the more established ones have different priorities. However, for working capital deployment, there are two fundamental areas of concern for companies in the early phase of operations to consider, whether it is the product or service or the sales revenue:
The product or the service that you are selling is, of course, the backbone of your business. In order to have a profitable business, you must spend time and resources on developing your product to the fullest. For already existing products, you may want to tweak it or add some additional features. There are many aspects of product or service which a business can consider for deploying their working capital on. These are:
- Market research
- Technical construction or manufacturing
- Screening and testing
- Modifications to the product
- Staffing and training
The ultimate goal of a business is to have an MSP, that is, minimum sellable product or a base product that customers are willing to pay for. This is above and beyond an essential product so that it can capture the attention of customers as a unique solution.
Sales generation is one of the most critical components of the growth and profitability of a business. It is imperative for a business to have stable, monthly and recurring revenues. This is crucial for all businesses and especially during the start-up period of a business where the business is connecting with potential clients and making sales. As such, once you have decided on making modifications or improving your core product, you must consider how you can deploy your working capital for the needs of your sales team.
The working capital deployment for sales varies from company to company and as per requirement. As a manager or the owner of your company, you may be managing the sales yourself or have a sales team working on that. Depending on the requirements, you can spend a portion of the working capital on the marketing and promotion, advertising of your product or promotions in order to increase your sales revenue. Ultimately, the whole purpose of deploying working capital into the business is to bring in more customers who can bring a profitable return as you meet your business expenses.
Costly Staffing Decisions
Many companies use up a large sum of their working capital on paying salaries and wages. If you are one of such businesses, then you must reconsider whether the people you have hired are bringing in the return as well or are just adding cost to your business. There are processes in the business that can be automated or maybe there are three people doing a job which can be done by one person. As such, you should review your staff and employees in order to cut your cost and deploy working capital in your business in the most productive manner.
Reasons for Deploying Working Capital
A business must decide what their priorities are when deciding how to deploy the working capital in the best possible way. Since the amount is limited and the business may need it quite frequently, they must prioritize their spending. However, there are many avenues where they can apply the working capital, as mentioned below:
- Bridge Delays in Collecting Account Receivables
Delays for receiving cash are quite common in most industries. Having working capital handy can help in meeting the cash requirements as they fall due.
- Purchase Inventory
It can be used to restock your inventory or your supplies or for purchasing new products to sell in your business.
- Sales and Marketing
Whether it is event sponsorship, local advertising or direct marketing campaigns, these are all quite common uses of working capital for most businesses.
- Hiring Employees
Cash from the working capital, as mentioned above, is also utilized for human resource expenses such as payroll, hiring bonuses, career fairs, employee events and more.
- Business Growth/Expansion
Working capital is also a useful form of finance when it comes to remodeling or renovating your office premises.
Many businesses also ensure working capital finance to meet their tax obligations, whether they pay annually or on a quarterly basis. It helps to bridge the cash flow during tax season.
- Update Equipment
You may need to upgrade your office equipment but do not have the cash for it. There may be a great deal going on in the market, and having access to cash can help you purchase the latest technology and equipment that can improve your business practices.
- Unexpected Expenses
For every business, unexpected expenses appear from time to time. Whether it is a new government law or regulation, sudden tax increases, machinery breakdown or changes in demand, working capital can help a business to meet these needs.
Read more on kickstarting your business with working capital.
Deploy Working Capital Smartly
The above is a comprehensive guide to working capital. It explains what is working capital, where is it used and why is it used. It also suggests which areas a business should focus on when they do have access to working capital financing. The main aim of a business should be to prioritize their business goals and then use the working capital funds in a smart and efficient way.
Having working capital does not mean the business should utilize the entire sum of money that they have. Instead, they can keep their line of credit for a rainy day and use it when it is needed the most. As such, having working capital for a business does not mean their problems are solved – using it and deploying the working capital most efficiently would ensure that the business can be successful.
Read more on working capital management.