But before you jump into the train of financing your working capital, there is a need to understand your current working capital ratio.
How do you compute your working capital ratio?
Working capital ratio can be computed through a relatively simple formula:
Working Capital = Current Assets – Current Liabilities
Remember however that your current assets don’t just mean the total amount of cash that you have in the bank. It also includes your inventory right along with your current Accounts Receivable. Meanwhile, your current liabilities comprise of your Accounts Payable right alongside your other long-term payables.
The end goals is to have a double portion of your assets more than your liabilities. In other words, a 2:1 ratio. Don’t stress too much over it though. Most businesses usually get 1:1 — the ideal ratio. Having 2:1 is already well above minimum.
Going below 1:1, however, means that your business is in the danger zone. It’s something to address even when you have the cash in the bank.
How to Finance Your Working Capital
The next big question to ask is whether or not financing your working capital actually makes sense for your type of business.
Are the funds you’re borrowing geared towards covering inventory that would pay for itself as time goes by? Is there a short-term gap that you need to cover?
Remember that if you don’t have the cash flow to complete periodic payments for short-term working capital loans, then it’s probably not the best course of action at this time.
And on that note, there are several main sources of capital so you can finance your needs for working capital loans.
Factoring is when a business sells every or selected accounts payables to a third party at a lower price than the actual value of those accounts. The third party that’s being sold to is known as the ‘factor’ who provides factoring services to businesses.
The factor provides the financing in buying the accounts, and at the same time, they collect the amount from the debtors. Plus, it comes in two types: without recourse and with recourse.
Credit risk of the debtor refusing to pay is borne by the business in factoring with recourse. On the other hand, it works the other way around for factoring without recourse.
Bank Overdrafts or Lines of Credit
This is perhaps one of the most beneficial and most appropriate types of working capital financing that’s widely used by both small and big businesses. It’s offered by commercial banks, and the borrower is permitted to hold a specific amount of money that can be used for meeting business payments.
What the borrower needs to do is not the cross the authorized limit
The interest is only charged on the amount of money that was used and not on the lump sum. This maneuver actually serves to motivate the borrower to maintain the original amount and keep on depositing to save significantly on interest costs.
Many business owners can agree that it’s one of the cost-effective ways of merchant financing.
Trade credit refers to the period of extension a creditor gives to a business. These are usually extended based on creditworthiness — which can easily be recorded and reflected in its earning records, payment records, and liquidity positions.
You’ll find that there are suppliers out there who would be willing to collaborate with their best customers to fund large orders and cushion a short-term financial need for more working capital. And they do it by lengthening payment terms.
However, trade credit has costs after the free crediting period is over. It might be preferable to some, but it can be a costly source of financing business working capital.
Short-term Small Business Loans
Many business opt for short-term SBA loans to meet an immediate need for their business financing without being burdened with a long-term loaning commitment. Short term loans are useful for covering temporary problems in funds to meet expenses like payrolls.
They can be classified in less than 2 years, and often last for 3-12 months.
other valuable tips from our business center:
Your Working Capital is Crucial
The main goal of properly managing your working capital and financing is to give your business the chance to continue operating. Most popular methods of financing working capital has the ability to meet the debts from short-term loans along with any operational expenses.
And in searching for the right method of financing for your small business’ working capital, it’s integral that you compare all of your options based on your current financial health.
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