What is working capital? There are several definitions and explanations being bandied about it online, but it’s actually very straightforward. “Working capital” usually refers the money you have right now minus the debts you need to pay right now or in the near future.
In short, working capital = immediate assets – immediate liabilities.
Your immediate assets include the money you have in your bank accounts, your inventory, and your accounts receivable. Your immediate liabilities include payroll, utility bills, supply expenses, office expenses, and short term debts.
For your business to operate smoothly, your working capital has to be a positive figure—you need to have more current assets than current liabilities.
If your current assets are less than your current liabilities, then you have a problem, because you don’t have to means to pay for your debts and obligations. You will then need a working capital loan.
How a Working Capital Loan Affects Your Working Capital
When you get a standard long term loan, it usually means you boost your working capital. For example, if you get a $100,000 loan payable in 3 years, then that means you increase your working capital by $100,000 because your immediate liabilities have not increased as well.
But with a short term working capital loan, you don’t boost your working capital. That’s because while you get the $100,000 to use right away, you also add $100,000 to your short term debts. That means there’s really no net difference to your working capital.
For example, let’s say you get an 80% advance on your accounts receivable now, with the rest coming to you when your customer pays up in full. You get more money now, but essentially you reduce the value of your accounts receivable. You basically end up not increasing your working capital at all. But you did improve your cash flow.
So What Increases Working Capital?
There are several ways to increase your working capital.
- You can get a long term loan. This is one of the main reasons why small businesses borrow money from banks on the first place. You get more money to use, but you don’t incur any immediate debts.
- You can boost your net income. Your net income is the money you earn minus the money you spend. This is the normal way of boosting working capital, since these profits can then be used to pay for current liabilities.
- You can sell a fixed asset, such a building or an expensive piece of machinery. This can really boost your working capital, especially if you sell something that you don’t really use.
Proper Use of Working Capital
Working capital, by definition, should be used to your benefit. Now having enough working capital is a problem, but so is having too much working capital. That means you’re not putting that money to good use. For example, you can use some of your excess working capital to buy useful fixed assets such as equipment or real estate.