As the saying goes, you have to spend money to make money. When starting or scaling a business, you’ll need to invest in certain assets, like inventory, space or employees, before you start making a profit. One measure of your current financial state is called working capital.
But, before you begin putting money toward equipment, supplies or other needed purchases, it’s critical to understand your current financial state. Knowing how much cash on hand you have, and how business operations will affect your available funds, allows you to make smart decisions about how to invest that money.
What is working capital?
Working capital is the difference between your current assets and current liabilities. Current assets include everything from the cash in your bank account to your inventory to the building you own or lease for the business. Essentially, current assets are anything that can or will reasonably be exchanged for cash in the next year.
Current liabilities are just the opposite. They are all of your expenses that are due within the next year. Rent, accounts payable, loans and any other debt that you are scheduled to pay off in the next 12 months is included here.
What is an operating cycle?
Knowing your working capital is necessary to begin understanding the financial well-being of your company. However, it hardly paints a complete picture. For example, if you need to make a purchase in the next week, knowing how much your inventory is worth for the next year isn’t helpful.
For a more accurate picture of how much cash you have to work with, you’ll also need to understand your operating cycle, Entrepreneur pointed out. This analyzes accounts receivable, inventory and accounts payable. Operating cycles are measures of the number of days it takes to:
- Collect on an account (accounts receivable days).
- Complete the sale of a product (inventory days).
- Pay an invoice (accounts payable days).
In an ideal world, a business could make all necessary payments using cash brought in from inventory and accounts receivable. But more often than not, these three measures don’t line up perfectly, and the cash a business is owed may not be available to make timely payments on invoices. In these instances, a reserve of cash is needed to make payments.
How can I qualify for a working capital loan?
The Balance pointed out that a good rule of thumb for maintaining a healthy business is having twice as much value in your current assets as you do in your current liabilities. However, when undergoing a change in your business structure, like when you’re expanding, this ratio is a challenge to reach.
Many business owners will, at some point or another, turn to a working capital loan when more cash is needed to start or grow a company. Some use this money to make large purchases, like new equipment or more workspace. Others use this for expenses while they’re scaling up their operation, such as for marketing, inventory or bill payments.
Obtaining a loan to boost your working capital fund is a good way to keep your business healthy, and it’s not difficult to do. If you can show that your business is in good standing, or that your plans for expansion will most likely pan out, you should be able to qualify for a loan from an alternative lender.
Different creditors will have different requirements for obtaining financing. These measures are put in place to protect the financial institutions from borrowers whose plans don’t work out as they had hoped. A few good things to have when you apply for a working capital loan include:
It should go without saying that lenders generally don’t like to give loans to people who are new to their industry. If you’ve been in business for at least a year, you can show a lender that you know what you’re doing and will work hard to protect their investment.
Your bank statements
Don’t just tell a lender you’re successful. Show them with your bank statements. Lenders like to see indisputable evidence that you know how to manage your company’s finances and that you’re smart with money. Your bank statements will tell them what they need to know in this regard. Bring at least three months’ worth of your most recent bank statements to give your lender a no-nonsense look into your company’s financial health.
Annual gross sales
What makes a business healthy? The ability to generate revenue. Your annual gross sales demonstrate this better than any other measure. Show your lender what your gross sales were last year. They don’t have to be huge but demonstrating that you know how to make money will make your lender more confident in investing in your operation.