Adequate working capital is critical for businesses of any size but, it is doubly so for small businesses and start-ups. Working capital represents a business’s ability to pay its short-term expenses. It’s a measure of cash flow and is computed by subtracting the company’s current liabilities from its current assets.
When a business has negative working capital — meaning that its current liabilities outstrip its current assets, there’s a chance that current expenses could overwhelm the business’s ability to settle them. For a small business that depends on healthy relationships with their vendors and debt partners, this can be a serious problem. Here are six reasons why it’s so important.
Working Capital Is Crucial for Day-To-Day Company Operations
Small businesses generally have both short-term and long-term financial obligations. The short-term obligations, those involved in maintaining proper inventory levels, paying vendors, employee salaries, and the myriad other expenses that factor into the day-to-day operations of the company must be kept current in order to maintain smooth business operations.
When a business falls behind on its current obligations they risk interruptions to their supply chain, employee churn, and a loss of critical vendor relationships. This makes it more difficult to satisfy customer demand adequately, which can lead to angry customers, stress and a loss of income, further decreasing working capital.
If this spiral is allowed to get out of hand, financial insolvency is likely, as day-to-day operations are no longer supportable. Having sufficient working capital is the best way to prevent this sort of negative result.
Small Businesses May Not Have Access to Financial Markets
When large businesses are faced with working capital shortfalls they can borrow money under attractive terms to help settle short term expenses or convert short-term debt into long-term debt.
Many small businesses don’t have the credit history, or the assets required to qualify for this sort of financing, at least not at interest rates that the business can afford. Because they lack this safety net, small businesses must keep a keen eye on their working capital to be certain their current expenses can be satisfied.
Proper, consistent management of working capital can have a secondary benefit, however. When a business is a good steward of current assets versus liabilities, paying all expenses, particularly its debt service payments, on time month after month it builds corporate credit, and can, in the long run, open up credit markets for help in the future.
Businesses Have Access to Better Purchase Options from Vendors
Businesses that have proper working capital and satisfy their liabilities on time will qualify for better terms from their vendors. This often translates to smaller purchase minimums, lower short-term financing rates, and better bulk pricing.
Better vendor terms allow for more effective inventory management practices, which further enhances working capital, setting up a positive feedback loop.
Businesses Are More Resilient Against Unexpected Shocks
If a business is already struggling with debt service or is having trouble satisfying other short-term obligations because of inadequate working capital levels, unexpected expenses or sudden reductions in income can have devastating results.
These shocks are much easier to weather when the business has the resources necessary to cover its normal expenses. It then only needs to worry about the new circumstances.
Competitive Advantages are Possible
Solid companies with proper working capital levels will operate more efficiently than less stable companies. They’ll have better-developed supply chains, preferred financing terms, and a more resilient production process.
This creates savings that can be passed on to the customer. Better prices at similar quality levels undercut the competition and represent a significant competitive advantage.
Working Capital Allows a Small Business to Grow
Having enough working capital to satisfy current obligations is critical, but just as important is what a company does with excess working capital. Maintaining levels in excess of what it takes to maintain day-to-day operations precludes a business from making the investments required to grow. To use working capital efficiently, overages should be invested back into the company.
Excess working capital allows a business to scale its operations, investing in new equipment, new lines of business, extra staff and other positive business investments. Growth is important for the long term health of the organization as it increases future opportunities and makes the company more valuable. It’s also a key factor in assuring financial stability in the face of long-term financial obligations.
Working Capital Is a Signal to Investors
While adequate levels signal that a business is able to satisfy its current expenses, it’s not a guarantee. However, many investors still use it as a signal for financial stability because it’s a generally strong indicator of financial health. If a business wants to appear healthy and be healthy, it should make certain to keep proper working capital levels.