If you don’t have enough working capital to meet payroll or pay your suppliers, then as a business owner you’re going to have a problem. A working capital loan can help but it really doesn’t improve your working capital at all. In fact, a working capital loan will generally not affect working capital.
Clarifying the Issue of “Working Capital”
If the title of this article doesn’t make sense, then let’s clarify the issue. Working capital is actually a technical term, and it’s defined as your current assets minus your current liabilities. Your current assets don’t count any fixed assets, but rather those items (such as invoices and inventory) which can be easily converted into cash. Your current liabilities are those which you need to pay for in the near future, so any long term loans don’t count.
So if you get a working capital loan, you get cash which makes it a current asset. At the same time, your current liabilities increase by the same amount. So there’s really no difference at all when it comes to your working capital.
However, keeping track of your working capital can be important. For example, you can tell that something’s wrong if your working capital is decreasing over time. It can also tell you if you are making good use of your assets.
If your working capital is negative (your current assets is less than your current liabilities) then you need to get more working capital right away. But if you have too much working capital (such as if your current assets are more than twice the value of current liabilities) then you may not be investing your extra cash properly or you have too much inventory.
So What Affects Working Capital?
So if a working capital loan will generally not affect working capital, what will?
- Your net income. This is your standard source of working capital. You exchange your inventory for a price that’s higher than the cost it took to manufacture it. Since the cost (liability) is less than the price (asset) you will get more working capital.
- You bought fixed assets. If you buy fixed assets like equipment, then you use your cash which is a current asset for something that’s not a current asset. This is one of the uses of working capital.
- You paid off a long term debt. This is another use of working capital, as a long term debt is not a current liability.
- You have a long term debt. This is one way of increasing working capital, because the loan doesn’t have to be paid in the near future.
- You sold a fixed asset. Perhaps you sold some equipment you no longer use, or a building you no longer need. This also increases your working capital.
Working capital is meant to be used. You need enough to operate and grow, but having too much means you’re not using it properly.
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