Most company owners, banks, and financial managers agree that some working capital is necessary for a business to operate smoothly because it provides a buffer against declining revenue. Working capital is vital to ensure the lights are kept on, payroll is covered, and vendors are paid. You can measure it weekly, monthly, or yearly as a pulse check for your firm’s financial health. However, knowing that your business has a specific amount of working capital available might not be enough. The crucial question is how much capital your company needs to have sufficient protection from financial bumps in the road and to maintain the company’s financial health. You may need to delve deeper to discover this figure. Not knowing it could mean you are operating your company in the dark. What is minimum working capital? Keep reading to find out.
More About Working Capital Management
Your company’s working capital is the amount of money you need available to pay your inventory, supplies, leases, and incidentals. There are formulas that you can use to give you a working capital baseline. Determining your working capital ratio can give you an idea of your company’s ability to meet short-term obligations:
Current Assets / Current Liabilities = Working Capital Ratio
The balance sheet provides a snapshot of current assets and current liabilities, which are essential for this calculation.
Calculating your net working capital will provide information on how much cash you have readily available to cover your current expenses:
Current Assets – Current Liabilities = Net Working Capital
The importance of cash flow in maintaining working capital cannot be overstated, as it is crucial for funding day-to-day operations and addressing liquidity challenges.
To make your calculations, use short-term assets including: ⦁ Inventory that will be sold within 12 months ⦁ Accounts receivable (including money owed to you from customers) ⦁ Cash in your checking, savings, and money market accounts ⦁ Cash equivalents
For your short-term liabilities, include: ⦁ Accounts payable money that you owe clients and other creditors ⦁ Accrued income tax payments ⦁ The interest your business pays on borrowed money
These liabilities are part of the company’s assets on the balance sheet.
Now that we have a basic understanding of how to calculate working capital, let’s take a closer look at the minimum working capital.
Minimum Working Capital Requirement and Current Liabilities
The least amount of cash you will need to cover your expenses and meet your short-term obligations is your minimum working capital requirement. Your company needs to determine an acceptable level of working capital to match its needs. Once you know this required amount, make sure you have it available before factoring in sales numbers. If you rely on a fluctuating number like revenue to cover costs (which are typically fixed), you will have to guess and hope the money will be there to finance your operations.
Ways to Meet Your Minimum Working Capital Requirement
Having minimum working capital to cover expenses will keep your company’s finances on solid ground. Operational efficiency is crucial in maintaining working capital by ensuring effective cash collection and managing payment terms with suppliers. Yet many business owners struggle to keep up with bills or pay for incidentals, let alone have access to enough working capital to meet minimum requirements. Implementing working capital management as a financial strategy can help ensure sufficient working capital to cover day-to-day operating expenses and invest resources productively.
Business Line of Credit
One way to do this is by opening a business line of credit. A business line of credit (or bank line) is a type of financing that offers more flexibility than a loan. The issuing financial institution allows you to borrow cash when you need it up to a fixed limit. Your credit line works like a credit card where you draw and repay funds how and when you need to. You only pay interest on the money utilized, and as you make payments your fixed limit is reset. Banks generally charge a lower interest rate for a line of credit, but you need decent credit to be approved for one. If not, and your personal credit hovers around 550-600, you could be charged an interest rate that ranges from 60%-99%. These are for credit lines up to $250,000. Most banks want your company to have a few years of history and substantial revenue to qualify. You will need to put up collateral for a larger bank line limit, which can be confiscated by the lender if you fail to pay. The company’s balance sheet is also crucial in the approval process, as it provides a comprehensive snapshot of the company’s financial position. These hurdles make it tough to qualify for a line of credit, even if you have support from the Small Business Administration (SBA).
Business Credit Cards and Accounts Receivable
Even though business credit cards are lines of credit, they differ in a few ways. A business line of credit provides a higher credit limit than a credit card, and when you make a draw, actual cash is issued to your bank. When you get a cash advance through your business credit card, you will be charged a higher annual percentage rate (APR) and other fees. Other business credit card fees include late-payment and annual fees. If you aren’t careful, all of this can add up to take a sizable chunk out of the minimum working capital you’ve calculated for your business, potentially leading to negative working capital if not managed properly. To be approved for a decent business credit card, your personal credit score should be 670 or higher. Even though business income will pay your balance, your individual credit score can be impacted if you miss payments. Maintaining positive working capital is crucial for ensuring financial stability and operational efficiency.
