For any business to maintain a day to day operation, it’s vital to hold sufficient working capital. Working capital, a measure of a company’s liquidity, looks at short-term assets like cash, materials, and inventories to help assess if a business is able to cover its current and upcoming financial obligations.
Having enough working capital is essential for businesses to handle basic obligations like payroll and taxes. On the other hand having too much working capital could be costly to a business, as those funds are locked away from being invested in future growth. Read more to learn about how to decide on the right level of working capital for your business and how working capital financing can come into play to help your business manage its financial needs.
What is Working Capital?
Working capital, sometimes referred to as net working capital or NWC for short, is the total of a company’s current assets less its current liabilities. Current assets include short-term and highly liquid assets like cash, inventories, and accounts receivables. Current liabilities are bills and other financial obligations. In most cases, current or short-term liabilities are expenses due within one year.
In short, current assets minus current liabilities equals working capital.
For example, if a company has $20,000 in cash in the bank, $15,000 in inventories, and is owed $15,000 for recent sales, it has current assets of $50,000. The same company owes $10,000 on a line of credit, $5,000 on its company credit card, and has outstanding bills to suppliers and a payroll provider for $15,000. The company’s current liabilities in this case are $30,000. Current assets of $50,000 less current liabilities of $30,000 would result in a net working capital of $20,000.
How to Determine Your Working Capital Needs
On the surface, one might assume that a higher level of working capital is always better. That’s true to some extent. It’s definitely better to have more short-term assets than short-term liabilities. But having too much tied up in working capital may also hold a business back from growth.
In the example above, we know what the business has and owes, but we don’t know its typical monthly expenses, seasonality trends, or industry. Some businesses, such as construction companies and banks, might require high levels of working capital compared to online media companies or accounting firms.
You know your business better than anyone else, so you are likely in the best position to decide on the right level of working capital for short-term needs. It’s important to have enough cash and liquid assets to pay the bills and meet customer needs. That includes cash to cover financial emergencies or unexpected business slowdowns. Many companies set a goal of 30, 45, 60, or 90 days of planned expenses on hand, for example, similar to a personal emergency fund.
Working Capital Financing
If you are concerned about running out of funds, working capital financing could offer a cost-effective alternative to keeping more cash in the bank. Credit cards and lines of credit, for example, could give a business same-day access to cash to help fund any operating needs.
Here are some common types of working capital financing used by businesses across Canada:
- Business credit cards: Business credit cards give you instant access to make business purchases without dipping into your cash pile. If you pay the balance in full before the next statement due date, you won’t pay any interest charges. However, paying back over time typically incurs financing charges.
- Business lines of credit: A business line of credit works like a credit card in some ways. If you need capital, you can draw on your credit line and pay it back over time with interest.
- Trade credit: Trade credit is a form of financing from your business’s suppliers. If you are given the option to pay your invoice 30, 60, or 90 days in the future, for example, the supplier is effectively giving you a short-term loan. This is sometimes referred to as vendor credit.
- Installment loans: Installment loans are best used for longer-term projects, though some businesses might use an installment loan for working capital.
As a business owner or manager, you have plenty of options when it comes to handling your working capital. Whether that’s keeping more cash in the bank or opening a new business credit card or line of credit, there is no right or wrong answer. Just what’s right for your business.
American Express offers a suite of working capital products for businesses of all sizes. If you want to learn more, contact American Express today.
This article is intended for general informational purposes only and does not constitute legal advice or an opinion on any issue. It should not be regarded as comprehensive or a substitute for professional advice.