How Much Working Capital Loans Do You Really Need?
Working capital refers to the actual cash and disposable assets available to support your business’ daily operations. If your available cash and liquid assets are not enough, you may apply for working capital loans. But, how much money do you really need?
Here’s a short guide on how to calculate the right amount of working capital loan you need to meet your current obligations.
List your current assets
Which of your assets can your company convert to cash within 12 months? Those are your current assets. They include inventory, pre-paid expenses, account receivables, short-term accounts, cash, cash equivalents and other assets entered on your company’s balance sheet.
Classify them into asset types and how long it will take you to convert those assets into cash. If more than half of your company’s assets are cash or convertible to cash then you only need a small amount of working capital. It’s because you can easily tap into your current assets during emergencies or when you need additional funds for your daily operations. But, if you have slow-moving inventory items and most of your assets cannot be easily converted into cash—then you need a larger amount of working capital to ensure that you have available funds during financial emergencies.
Compute your current liabilities
What are the credit accounts that you have to pay within a year? You can also include suppliers, wages, taxes and other forms of accrued liabilities and accounts payable that you have to pay within the year. Calculate your working capital. Get the total of your current liabilities and subtract it from your total current assets.
For example, your company-Baby Lab has a current asset worth $100,000 and you have a total of $50,000 current liabilities. Let’s compute: $100,000 Assets minus $50,000 liabilities equals $50,000 working capital. That means, you have a working capital amounting to $50,000. The said amount would be the left over cash to serve relevant business expenses while your remaining $50,000 will help you pay all your current liabilities out of your current assets.
But, what will happen if your asset is worth $100,000 but your liabilities amount to $110,000? When your current assets are lesser than your current assets, it means that you have a working capital deficit. It means that your business is at risk of not being able to pay its debts when they become due). That is a sign of insolvency. To save your company from becoming insolvent, you may need other sources of long-term financing, such as working capital loan. This type of loan can be used to pay long-term debts and other financing operations. If you’re short in cash but you want to distribute money to your shareholders anyway, then you can also use the proceeds of the loan to do so.
In the given example, a $20,000 deficit means that your company can only pay for the $100,000 and you may have to sell some of your long-term assets ort apply for a loan equivalent to the deficit amount.
Analyze the nature of your sales or working capital turnover
Do you have very consistent sales nowadays? If so, do your customers pay within 30 days or 60 days? If your customers pay with credit cards whenever they place the order, you only need a small amount of working capital. But, if you have a grace period of 60 days and you need to pay your suppliers within the same period, or half the time, you need a larger working capital to meet the demands and pay your suppliers.
Working capital turnover analyzes the relationship between the money you used to fun your operations and the money you make out of the sales generated from these operations. For example, Baby Lab Company has current assets amounting to $1 Million and liabilities worth $500,000 and a working capital of $500,000.
Now, let us compute the working capital turnover ratio to measure how well your company is utilizing your $500,000 working capital to support your sales.
Divide the amount of net sales by the amount of your working capital. If Baby Lab Company has $1 million of net sales over the past 12 months and the average working capital during that time was $500,000, its working capital turnover ratio is $1million/500,000=2. How will you know if your turnover ratio is high or low? You have to compare it with your competitors. If the companies selling similar products or offering similar services as yours have working capital turnover ratios of 5, 4 and 3, it means that your ratio of 2 is lower than theirs.
A low working capital turnover ratio means that you don’t have a competitive advantage in your industry. It indicates that you’re not maximizing the use of your capital per year and that you don’t have spending flexibility. It also means that money is not running smoothly in and out of your business and you may have to face financial troubles within the year.
If you experience more demand for your services or products, you are more likely to complain of inventory shortages.
Do you want to learn more about working capital loans and what it can do to improve your sales and working capital turnover? Contact Business Loans today.