Boost Your Small Business Finances By Understanding Net Working Capital
Does this sound familiar? You go to the bank to get a small business loan so you can grow and the first question you are asked is “how much money do you need?” Assuming you already have a number in mind, how do you convince the bank to lend your business that amount? And if you don’t know how much money you need, how can you figure it out?
As a small business owner, understanding your net working capital can be a useful tool to your financial success. net working capital is a measure of your company's liquidity, or its ability to meet short-term obligations. It is calculated as the difference between your current assets and current liabilities. Knowing your net working capital can help you determine whether you have enough cash on an ongoing basis to make timely loan payments, which obviously impacts ability to obtain financing from investors and financial institutions.
Net Working Capital Calculation
To calculate your net working capital, you need to first determine your current assets and current liabilities. Current assets include cash, accounts receivable, and inventory, while current liabilities include accounts payable and short-term debt. Once you have this information, you can subtract your current liabilities from your current assets to determine your net working capital.
For example, if your current assets are $100,000 and your current liabilities are $75,000, your net working capital would be $25,000.
Importance of Net Working Capital
Net working capital is an important measure of a company's financial health. A positive net working capital indicates that a company has sufficient short-term assets to cover its obligations, which can make it more attractive to potential investors or lenders. If your net working capital is negative, it means you have more current liabilities than assets, which can indicate financial distress. Many times, the loan terms will specify that a company maintain a minimum level of working capital as a method of mitigating their risk.
Net Working Capital As A Percentage of Sales
Net working capital can also be calculated as a percentage of sales as a useful metric for evaluating your company's financial health over time. By dividing your net working capital by your annual sales revenue, you can get a sense of how much working capital you need to support your operations on an ongoing basis. This can help you make better decisions about inventory management, payment terms, and other factors that impact your net working capital.
For example, if your net working capital is $25,000 and your annual sales revenue is $500,000, your net working capital as a percentage of sales would be 5%.
This means that you need to maintain at least 5% of your sales revenue in working capital to support your operations. If your net working capital as a percentage of sales is consistently below this level, it may be a sign that you need to take steps to improve your financial health.
Tips For Managing Net Working Capital
Accurate and consistent bookkeeping can help you mange the net working capital for your business, so here are some things to keep in mind:
Keep track of incoming and outgoing cash flow
Accurate bookkeeping starts with keeping track of all incoming and outgoing cash flow. This includes sales, expenses, and any other transactions that impact your net working capital. By regularly tracking your cash flow, you can identify potential cash shortfalls or surpluses and take steps to manage them.
Record all expenses and income, including accounts receivable and accounts payable
To effectively manage your net working capital, it's important to accurately record all expenses and income. This includes tracking accounts receivable (money owed to your business by customers) and accounts payable (money your business owes to suppliers or vendors). By maintaining accurate records, you can ensure that you have enough cash to cover your short-term obligations and avoid any surprises.
Manage inventory effectively to avoid tying up cash
Holding too much inventory can tie up cash that could be used for other purposes, while not having enough inventory can result in lost sales. To manage inventory effectively, consider using inventory management software to track inventory levels and sales trends. This can help you optimize your inventory levels and avoid tying up cash unnecessarily.
Negotiate payment terms with suppliers
Negotiating payment terms with your suppliers can help improve your net working capital by allowing you to defer payment until a later date. This can free up cash in the short term and give you more flexibility in managing your working capital. However, it's important to negotiate payment terms that are realistic and manageable, to avoid any negative impact on your supplier relationships.
Stay on top of accounts receivable to ensure timely payments
Managing accounts receivable effectively is key to maintaining a positive net working capital. This means following up with customers who haven't paid their invoices on time and taking steps to collect overdue payments. Consider implementing a system to track and manage accounts receivable, such as sending reminders or automating payment processing.
Conclusion
Ultimately, understanding and accurately managing your net working capital can help your small business apply for and receive financing. By calculating your net working capital and monitoring it regularly, you can ensure that you have enough liquidity to cover your short-term obligations, improving your chances of obtaining financing from investors and financial institutions. Accurate bookkeeping is essential to managing your net working capital effectively, so be sure to keep track of your incoming and outgoing cash flow, manage your inventory, negotiate payment terms, and stay on top of your accounts receivable. Finally, remember that net working capital as a percentage of sales is a useful metric for evaluating your company’s financial health over time, and can help you make better decisions about managing your working capital.
By using these strategies, you can improve your net working capital, increase your company's financial stability, and position yourself for long-term success. As a small business owner, it's important to stay informed about your company's finances and take proactive steps to manage your net working capital effectively. With a clear understanding of net working capital and its importance, you can make informed decisions that support the growth and success of your business.
