Working capital: What it is and when to consider a working capital loan
Whether you’re operating a law practice, med spa, engineering firm, or any other business, a certain amount of cash is required to cover day-to-day expenses—and to meet short-term obligations. The cash on hand is known as working capital. This article examines what working capital is, how to calculate it, and why it matters to the short-term health of a business.
What is working capital?
Working capital is a metric of liquidity. The amount of working capital required depends on the type of business. Some businesses have long periods of low sales—perhaps due to being seasonal or having long production cycles (such as a tech company building a new software product). Others serve many customers each day and can generate revenue at a higher rate as long as demand exists (such as restaurants and retailers). Each of these, however, requires some amount of working capital to succeed.
In terms of determining a specific business’ working capital needs, one must consider multiple key factors, including:
Near-term repayments of debts
Cash inflow/financial resources
How to calculate working capital
This section will help you calculate the working capital and working capital ratio for your business.
Working capital is derived from a variety of assets (specifically liquid assets) and immediate debts as reported on the balance sheet. Use this formula to understand your business’ liquidity:
Current Assets – Current Liabilities = Working Capital
Current assets: The business’ cash, cash equivalents, accounts receivable, and any assets (such as inventory) that can be converted into cash within one year
Current liabilities: Any debts or other financial liabilities that must be paid within one year
The result of the formula is your business’ working capital stated as a dollar amount. Let’s explore an example for illustrative purposes.
Image is an example only and does not reflect actual customer information.
In this case, we have $300,000 in total current assets and $275,000 in total current liabilities.
Now, let’s do the math:
To identify the ideal amount of working capital, start by plotting month-by-month inflows and outflows for your business and closely monitor your working capital ratio.
Determine the working capital ratio
The ratio is a useful tool that offers quick insight into whether your business’ working capital is sufficient. Essentially, your business’ existing assets must be able to cover current liabilities.
Here’s how the working capital ratio is calculated:
Current Assets / Current Liabilities = Working Capital Ratio
A net positive ratio (between 1.2 and 2) tells you that your business has adequate working capital. A ratio below 1.2, such as in our example, signifies that your business may have an insufficient financial cushion in the short term and could benefit from a boost in liquidity.
Finally, a negative ratio (lower than 1) indicates that the business is likely to experience difficulty paying back its creditors and, in most cases, must promptly address its working capital needs.
Common reasons to get a working capital loan
Businesses like the one in the example above require financing to ensure they have the working capital needed to support their daily operations and fulfill their short-term obligations. There are many reasons a business may not have adequate working capital. Here are the most common ones:
Late payments from customers
Cash flow is affected when customers pay late. A business must ensure that their accounts receivable operation is as streamlined as possible. Understanding that cash flow isn't always predictable, these businesses can benefit from a working capital loan.
Liquidity varies for most companies. This is especially true for seasonal businesses, where sales are known to slow down during certain times of the year. Similarly, it’s common for other types of businesses to have to wait to see a return (such as those which need to purchase inventory that will not arrive for several months). A working capital loan can see a business through these waiting periods.
An upshot in sales is usually a good thing—unless the company is unequipped to meet demand. To take advantage of an event like this, the company may need a working capital loan to purchase/fund the necessary resources to ramp up operations.
A lucrative opportunity may arise that a business is not prepared to meet. Sometimes, it requires an upfront investment that may not produce ROI for some time. To ensure a business owner can pursue a new venture while maintaining their primary operation, they may consider a working capital loan.
BHG is your solution for working capital
If your business requires additional working capital, BHG Money offers financing up to $500,0001,2 and terms of up to 12 years1—giving you a loan with affordable monthly payments. And with a flexible use of funds, you can cover multiple initiatives with one solution, from purchasing inventory to upgrading your security and technology to hiring an expert to optimize your firm.
Get started by using our online payment estimator to view your personalized loan estimate in seconds, without affecting your credit score.
You can also learn more about partnering with BHG to help your business thrive by checking out our Working Capital Loans page.
¹ Terms subject to credit approval upon completion of an application. Loan sizes, interest rates, and loan terms vary based on the applicant's credit profile. Finance amount may vary depending on the applicant's state of residence.
² BHG Money business loans typically range from $20,000 to $250,000; however, well-qualified borrowers may be eligible for business loans up to $500,000.
No application fees, commitment, or impact on personal credit to estimate your payment.
For California Residents: BHG Money loans made or arranged pursuant to a California Financing Law license - Number 603G493.