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Working capital is the lifeblood of any business, as it is necessary for day-to-day operations and covers the costs of running a company. It refers to the difference between a company's current assets and current liabilities.
You need to know the different types of working capital, which are essential for businesses to maintain their financial stability and liquidity. From gross working capital to operating working capital, this is a comprehensive guide to help business owners understand the importance of each type and how to manage their working capital effectively.
- Working capital is the difference between a company’s current assets and current liabilities.
- Business owners will find 8 different types of working capital to consider.
- A clear understanding of different types of working capital will help more effectively determine where your business liquidity stands.
8 Types Of Working Capital
Working capital offers an assessment of a company’s liquidity. When you subtract a company's current liabilities from its current assets, you’ll quickly determine whether or not the company has enough liquidity to stay on top of its financial obligations.
Determining basic working capital is a good place to start. But understanding different types of working capital can help you monitor your business more efficiently.
The different types of working capital are most appropriate for different types of businesses. You’ll learn more about how each type is used below.
1. Permanent Working Capital
Permanent working capital is sometimes called fixed working capital. It assesses the minimum amount of funds that must be available in cash or current assets for a business to meet its current liabilities.
Typically, a bigger business requires a larger amount of permanent working capital. But the amount required varies based on the size and growth of the business.
How it’s used: Business owners can determine what amount of funds are required to continue to meet all financial obligations. With an eye on this number, you can make more efficient business decisions.
2. Temporary Working Capital
Temporary working capital is sometimes called variable, cyclical, or fluctuating working capital. You can calculate it by finding the difference between net working capital and permanent working capital.
How it’s used: As a business evolves over time, its temporary working capital needs will change. For example, taking on more debt could adjust the temporary working capital needs until the loan is paid off.
3. Regular Working Capital
The day-to-day operations of the business are covered by regular working capital. Typically, only the absolute bare-bones expenses are included in this calculation. Some expenses regularly included in regular working capital are wages, rent, and electricity.
How it’s used: A clear evaluation of regular working capital can help you determine exactly how much money you need to keep the doors open. It’s a helpful benchmark number to consider as a business owner.
4. Reserve Margin Working Capital
Reserve margin working capital looks beyond the day-to-day operations of the business. Instead, it indicates a set amount of funds dedicated to cover unexpected expenses.
How it’s used: Reserve margin working capital is almost like an emergency fund for your business. If an unforeseen expense arises, you can dip into these funds.
5. Seasonal Variable Working Capital
Seasonal demand is a relevant issue for many businesses. If your business sees seasonal swings, seasonable variable working capital determines how much working capital you’ll need at the peak season. Depending on the situation, business owners may borrow funds to capitalize on the demand.
How it’s used: As the peak season approaches, business owners can work up how much funding they’ll need to come up with for the impending demand.
6. Special Variable Working Capital
Not every business expense is a long-term choice. For example, marketing campaigns and repairing fire damage are temporary expenses that impact your special variable cash flow. Typically, these special projects involve boosting your working capital needs for a set period of time.
How it’s used: Special variable working capital is important for business owners facing short-term expenses. It helps you recalibrate until the short-term expense is eliminated.
7. Gross Working Capital
Gross working capital is considered the capital a company can access quickly based on assets that can be converted to cash. With that, gross working capital is equal to the total relatively liquid assets owned by the business.
How it’s used: Gross working capital gives business owners a metric of how much money they can quickly access if necessary. The tally includes assets like cash, accounts receivable, inventory, short-term investments, and marketable securities.
8. Net Working Capital
Net working capital is the difference between current assets and current liabilities. Depending on the situation, net working capital can be positive or negative.
How it’s used: Net working capital offers a helpful estimate of whether or not a company is able to meet its short-term financial obligations.
Factors That Determine Working Capital
Every company has slightly different working capital needs. Here’s a closer look at the factors that can impact working capital.
Size And Industry Of The Company
Companies of various sizes and industries have different working capital needs.
Size: The size of the company has a big impact on working capital needs. After all, it makes sense that larger companies with bigger payrolls or more significant fixed assets would require more working capital.
Industry: Different industries tend to approach working capital differently. For example, retail companies tend to need a larger working capital than other types of businesses.
The business cycle impacts working capital needs.
Growth phase: If the business cycle is growing, that can lead to growth opportunities. With that, most companies tend to need more working capital during this period.
Contraction phase: When the economy is contracting, demand for various items shrinks. With falling demand, companies tend to need less working capital.
The production cycle, or an operating cycle, creates ebbs and flows in working capital needs.
Timeline from raw material to finished product: A short timeline from start to finish often means lower working capital requirements. But if it takes months for the raw materials to become a final product, the company likely needs more working capital.
Demand for certain items rises and falls throughout the year. For companies with seasonal demands, working capital demands change with the seasons.
Peak season: In most cases, businesses need more working capital during the peak season to fund purchases.
Off-season: In the off-season, most companies can get away with a lower amount of working capital on hand.
Efficiency Of Operations
How efficiently a business runs has an impact on its working capital requirements.
Efficiency leads to lower working capital requirements: If a business can shorten production timelines, it can usually lower its working capital needs.
Payment collection: If a business can collect its accounts receivables efficiently, that often increases working capital.
Working Capital Finance
Working capital finance refers to the funds that businesses use to meet their short-term operational needs. It is essential for companies to maintain adequate working capital to ensure that they can pay their suppliers, employees, and other expenses on time. Working capital finance can come in various forms, such as loans, lines of credit, trade credit, and factoring.
Loans: Working capital loans are a common form of financing that businesses use to cover their short-term cash needs. These loans may be secured or unsecured and may have a fixed or variable interest rate. They are typically used for purchasing inventory, paying suppliers, or covering other short-term expenses.
Lines of Credit: A line of credit is a type of financing that allows businesses to draw funds up to a predetermined credit limit. This type of financing is flexible and can be used to cover short-term cash needs as they arise.
Trade Credit: Trade credit is an arrangement where a supplier provides goods or services to a buyer on credit. It is a common form of working capital financing that allows businesses to defer payment for a certain period, typically 30 to 90 days.
Factoring: Factoring is a type of financing where a company sells its accounts receivable to a third-party factoring company at a discount. This allows the company to receive immediate cash for its outstanding invoices, which can help improve its cash flow and working capital position.
Working capital finance is an essential aspect of managing a business's cash flow and ensuring that it can operate effectively. By understanding the different types of working capital finance available, businesses can choose the most appropriate form of financing to meet their short-term operational needs.
Types Of Working Capital Loans And Financing
There are various types of working capital loans and financing available to businesses. Here are some of the most common ones:
Term Loans: Term loans are a type of working capital financing that provides businesses with a lump sum of money that is repaid over a set period, typically one to five years. They are usually used for long-term investments, such as purchasing equipment or expanding operations.
Lines of Credit: A line of credit is a revolving loan that provides businesses with access to a predetermined credit limit that can be drawn upon as needed. This type of financing is often used to cover short-term cash needs, such as paying suppliers or covering payroll.
Invoice Factoring: Invoice factoring is a financing option where businesses sell their outstanding invoices to a third-party factoring company at a discount. The factoring company then collects the outstanding amounts from the customers, providing the business with immediate cash to cover its working capital needs.
Merchant Cash Advances: Merchant cash advances are a type of working capital financing that provides businesses with a lump sum of money in exchange for a percentage of their future credit and debit card sales. This type of financing is often used by businesses with high volumes of credit and debit card transactions, such as restaurants and retail stores.
Asset-Based Loans: Asset-based loans are a type of working capital financing that is secured by a company's assets, such as accounts receivable, inventory, or equipment. This type of financing is often used by businesses that have valuable assets but may have difficulty obtaining traditional financing due to their credit history.
Trade Credit: Trade credit is a type of working capital financing that allows businesses to purchase goods or services from suppliers on credit. This allows businesses to defer payment for a certain period, typically 30 to 90 days, which can help improve their cash flow and working capital position.
The type of working capital loan or financing that a business chooses will depend on its specific needs and financial situation. It is important for businesses to carefully consider the terms and conditions of each type of financing before making a decision to ensure that they choose the option that is best suited for their needs.
Eligibility For Working Capital Loans
The eligibility criteria for working capital loans can vary depending on the lender and the type of financing. However, here are some common factors that lenders may consider when evaluating a business's eligibility for a working capital loan:
Business age and revenue: Lenders may consider how long the business has been operating and its annual revenue to determine its financial stability and ability to repay the loan.
Credit score: Lenders may check the business owner's credit score to assess their creditworthiness and ability to repay the loan.
Cash flow: Lenders may review the business's cash flow to determine if it has sufficient income to meet its ongoing expenses and repay the loan.
Collateral: Depending on the type of loan, lenders may require collateral, such as inventory, accounts receivable, or equipment, to secure the loan.
Industry and business type: Some lenders may specialize in working with businesses in certain industries or have specific requirements based on the type of business, such as a franchise or startup.
Business plan: Lenders may review the business's plan to determine its long-term goals, projected growth, and potential for success.
The eligibility criteria for working capital loans can vary depending on the lender and the type of financing. It is important for businesses to research and compare lenders to find the one that offers the best terms and requirements for their specific needs.
Working Capital Loan Terms And Interest Rates
Here's a table that outlines some common working capital loan terms and interest rates
|Loan Type||Loan Amount||Repayment Term||Interest Rate||Collateral|
|Term Loans||$10,000-$500,000||1-5 years||4%-20%||Typically requires collateral|
|Lines of Credit||$10,000-$250,000||Revolving||8%-25%||May require collateral|
|Invoice Factoring||Up to 80% of invoice value||30-90 days||0.5%-5% per month||Collateral is the invoice|
|Merchant Cash Advances||$5,000-$500,000||3-18 months||Factor rate of 1.1-1.5||Repayment is a percentage of daily sales|
|Asset-Based Loans||Up to 85% of asset value||1-5 years||7%-17%||Requires collateral based on asset value|
|Trade Credit||Up to 90 days||N/A||N/A||No collateral|
Note that the above terms and rates are not exhaustive and may vary based on the lender and specific loan agreement. It's important for businesses to thoroughly research and compare lenders to find the one that offers the best terms and requirements for their specific needs.
Term Loans Vs. Lines Of Credit: Which Is The Better Option For Your Working Capital Needs
When it comes to financing working capital needs, term loans and lines of credit are two common options that businesses can consider. Both term loans and lines of credit offer businesses access to funding that they can use to cover their day-to-day operating expenses and cash flow needs.
However, there are important differences between these two types of financing that businesses should be aware of before deciding which option is right for them.
Term loans are a type of financing where businesses borrow a lump sum of money from a lender and repay it over a fixed term, typically with regular payments of principal and interest. Term loans can be secured or unsecured, and they may have fixed or variable interest rates.
The advantage of term loans is that they provide businesses with a predictable repayment schedule, which can make it easier for them to plan their cash flow and budget for their expenses.
However, the downside of term loans is that they often have strict eligibility criteria, such as a minimum credit score or a certain level of revenue, and they may require collateral to secure the loan.
Lines of credit, on the other hand, are a type of financing where businesses can draw funds from a credit line as needed, up to a certain limit, and only pay interest on the amount borrowed. Lines of credit can be secured or unsecured, and they may have variable interest rates that can change over time.
The advantage of lines of credit is that they offer businesses more flexibility than term loans, as they can borrow only what they need, when they need it, and they can repay the borrowed amount and then borrow again as needed.
However, the downside of lines of credit is that they may have higher interest rates than term loans, and they may require businesses to have a strong credit history and a solid track record of revenue.
Ultimately, the choice between term loans and lines of credit will depend on a variety of factors, such as the amount of funding needed, the business's credit history and revenue, the nature of the business's cash flow needs, and the business's ability to provide collateral.
For example, a business with a strong credit history and a predictable cash flow may be better suited for a term loan, while a business with fluctuating cash flow needs may benefit from a line of credit. It's important for businesses to carefully consider these factors and to consult with a financial advisor or lender before making a decision about which financing option is right for them.
Trade Credit: How It Works And When To Use It For Your Working Capital Needs
Trade credit is a type of financing where businesses can purchase goods or services from suppliers on credit, with payment due at a later date, typically within 30 to 90 days. Trade credit can be a useful tool for businesses that need to manage their working capital needs, as it allows them to obtain the goods and services they need to operate their business without having to immediately pay for them.
When a business uses trade credit, they are essentially taking out a short-term loan from their supplier, which can help them bridge the gap between paying for their expenses and receiving payment from their customers. The terms of trade credit can vary depending on the supplier and the business's creditworthiness, and they may include interest or other fees.
One of the key advantages of trade credit is that it can help businesses manage their cash flow, as it allows them to delay payment for their expenses until they have received payment from their customers. This can be particularly helpful for businesses that have seasonal or cyclical cash flow needs, as it can help them manage their expenses during periods when revenue is lower.
Another advantage of trade credit is that it can be easier to obtain than other types of financing, as it doesn't typically require collateral or a strong credit history. However, businesses should be aware that using trade credit can also have disadvantages, such as the risk of late payment fees or damage to their credit rating if they fail to pay on time.
Trade credit can be a useful tool for businesses that need to manage their working capital needs, but it's important to use it wisely and to carefully consider the terms and conditions before agreeing to credit with suppliers.
Businesses should also have a plan in place for how they will repay their trade credit obligations and should monitor their cash flow closely to ensure they can meet their payment obligations.
Invoice Factoring: A Quick And Easy Way To Improve Your Cash Flow
Invoice factoring is a financing option that businesses can use to improve their cash flow. With invoice factoring, a business sells its outstanding invoices to a factoring company at a discounted rate, in exchange for immediate cash. The factoring company then takes over the responsibility of collecting the payments from the customers on the invoices.
The advantage of invoice factoring is that it provides businesses with immediate cash flow, which they can use to cover their operating expenses, pay employees, or invest in their business. This can be particularly helpful for businesses that have long payment cycles or that need to manage their cash flow during periods of growth or expansion.
Another advantage of invoice factoring is that it can be relatively easy to obtain, as it doesn't typically require collateral or a strong credit history. Instead, the factoring company will typically evaluate the creditworthiness of the business's customers, as they will be responsible for paying the invoices.
However, it's important for businesses to carefully consider the costs of invoice factoring, as the factoring company will typically charge a fee or a discount rate for their services.
This can be higher than the interest rate on other types of financing, such as a line of credit or a term loan. Businesses should also be aware that invoice factoring can have an impact on their relationships with their customers, as the factoring company will take over the responsibility of collecting the payments from the customers on the invoices.
Invoice factoring can be a quick and easy way for businesses to improve their cash flow, but it's important to carefully consider the costs and potential impact on customer relationships before deciding to use this financing option.
Businesses should also work with a reputable factoring company and carefully review the terms and conditions of the factoring agreement before agreeing to sell their invoices.
In conclusion, understanding the different types of working capital can be crucial for businesses that want to effectively manage their cash flow and stay competitive in their industries. Whether you're considering a short-term loan, a line of credit, invoice factoring, or another type of financing, it's important to carefully evaluate your business's needs, financial situation, and goals to determine the best option for your working capital needs.
Here are three frequently asked questions about working capital: