As every business owner or manager knows, one of the most crucial factors that can determine how a business will grow and succeed will be the amount of working capital it has. You need working capital to function. You use it to pay for your overhead expenses, payroll, and purchase products or raw materials for your inventory. This is why some businesses apply for a working capital loan. But what some may not realize is that a working capital loan will generally not affect their working capital.
What is Working Capital?
Part of the confusion lies in the fact that some business owners do not really understand what “working capital” is. It’s not just the cash you have that allows you to pay for all your operational expenses.
Technically speaking, working capital is what you have when you take all your current assets and then you take away all your current liabilities. The key word here is “current”. This means the asset is something that you can convert to cash easily (as in within a year or less). Your current liabilities are then what you need to pay for within a year.
So when you calculate your working capital, you try to determine how much cash your business has when you have to pay supplier invoices when they are due. You have to determine just how long you have and figure out how long it takes for your inventory to turn into accounts receivables and then into cash. You do the same with your supplier’s invoices and for your immediate needs, such as overhead and payroll. If your cash isn’t sufficient, then you’ll need a working capital loan to help you pay for what you need.
Working Capital Loan
So how do you get some working capital? There are several methods. One traditional way is to get additional funding from investors. For example, you can get some more cash in exchange for a percentage of your company. You and your investor may agree that your business may be worth exactly a million dollars, so the investor can give you $100,000 for 10% of your business.
You can also get a loan from a bank and other lenders. For example, you can get a set amount of money, or you can get a line of credit much like a credit card. With a line of credit, you have a maximum amount you can borrow, but you can borrow only what you need so you don’t have to pay interest in borrowed money you won’t need. With a working capital loan, you have more cash in hand, but you also get more liability because you still have to pay for that loan.
So this is why a working capital loan will generally not affect working capital. You do have more cash available to pay for your working capital expenses, but your assets and your liabilities remain the same. You increase your assets, but your liabilities increase by the same amount as well.