Accounting professionals like to throw around terms that sound confusing, but are actually quite simple. Net working capital is also known as just working capital by most business professionals. The terms are interchangeable and they mean exactly the same thing. Before we can begin a discussion of how a bank can help with net working capital, we first need to examine the formula used to derive the net working capital figure.
Short-Term Assets – Short-Term Expenses = Net Working Capital
Your short-term assets are essentially cash, on-hand inventory, and pending accounts receivables. Your short-term expenses are normally grouped under your accounts payable, but they are also referred to as any payable that comes due in the next six months. Some accountants use 12 months instead of six months, but the idea is the same.
When you look at this formula, it seems pretty simple to calculate. But when it comes to working capital, the problem is not in calculating the final number. The problem is in getting a number that is accurate enough to allow you to make correct projections on available cash reserves. Anyone who has been in the business world long enough can look at the elements of this formula and immediately see two areas where the numbers can get skewed, which would cause net working capital to become a very unreliable figure.
The money you invested in your on-hand inventory is not always the value that you get back. This is a simple fact that all business owners have to live with everyday and it is something that can cause problems with the net working capital numbers. For example, let’s say you purchased an inventory piece for $10. When you bought the piece it was selling for $20, so your profit was $10. Two weeks after you bought the piece, the bottom of the market fell out for that piece and now it is only selling for $5. Now you are going to lose $5 when you sell that piece. You still paid $10 for it, but now it is only worth $5. Those are the kinds of things that throw off net working capital numbers on a regular basis.
You can protect yourself by investing in an efficient inventory monitoring system and keeping a close eye on your purchasing activities. You can also work out a deal with your suppliers that allows you to have product returned within 30 days and you would only pay a small restocking fee. There are ways to protect your inventory investment, but that does not prevent the volatility of your inventory value from making it difficult to pin down a net working capital number.
Every business owner wants to believe that they will send out invoices to their clients and their clients will send back payment on or before each invoice due date. But the business world does not work like that, which makes accounts receivables extremely unpredictable. It is almost better if your clients at least establish reliable trends when it comes to paying their bills late. That would at least allow you to be able to schedule payments and figure your working capital number more accurately. But different things happen at different times to different clients and your receivables wind up becoming a mess.
There are several different ways that you can improve the reliability of your receivables and get a more accurate working capital number. You can look into services such as invoice factoring which can use your invoices as collateral against cash advances. You can also try to offer incentives to clients to have them pay their invoices early. If your company is willing to give up one to two percent of its revenue just to get paid on time, then an incentive plan is worth looking into. When it comes right down to it, your cash flow is delicate and you need to do everything you can to make it as stable and healthy as possible.
The reason that the unpredictable nature of most corporate short-term assets does not put more companies out of business is because working capital spending is usually planned well in advance. A company knows at least a year in advance as to when their payroll deposits will be due and most vendor invoice payments can be scheduled at least 30 days in advance. Vendors that supply an ongoing service and provide regular invoices can have their payments planned out months in advance, which makes meeting those financial obligations much easier. In other words, working capital expenses usually do not sneak up on a company and cause immediate financial hardships.
Since your working capital usage is planned well in advance, it is possible to fill in the holes of your funding needs with bank loans. When you have a lender that you work with on a regular basis, then you can sit down with your accounts payable schedule and determine where your company is going to need help with net working capital. As long as your company has the proper kind of planning in place, then it should be relatively easy to see where there will be a need for assistance. At that point, you can work with your bank to plan on using working capital loans to meet your needs and keep your company going.
One of the things that banks excel at is planning ahead for future financial needs. As your company examines its net working capital situation, it is always a good idea to get a bank representative involved in the planning process to make sure that working capital loans will be available when needed. Your bank has plenty of online planning tools that allow you to examine your upcoming budget and then plug in loans where you may need them. Instead of wondering how you will make your payroll deposit when cash flow is slow, all you need to do is get a working capital loan and the problem is solved.
The more business you do with your bank, the more familiar the bank becomes with your business. Over time, your bank will be able to anticipate your working capital needs and have plans in place to offer financial help when you need it. Your company should avoid relying too heavily on working capital loans to provide the ongoing cash reserves you need to meet operational expenses. But it is always a good idea to have a strong financial partner in your corner when the cash reserves are low and the invoiced sales are slowing down as well. Work closely with your bank on your net working capital needs and you will be able to keep your company moving in the right direction.