What Does “Working Capital” Mean?
The Definition of “Capital”
In business, working capital is a fancy way of saying “money”. Technically speaking, the word “Capital” is defined by the Merriam-Webster Dictionary as “Capital actively turned over in or available for use in the course of business activity”. Many different terms are using the word “capital” in their name like “Capital Assets”, “Operating Capital”, and “Capital Goods”. In general, the word “Capital” is used to describe different components of a business’ holdings.
When financial managers are talking about the assets of a company, they are talking about several things under one umbrella. Capital Assets include cash as well as other valuable assets like accounts receivable, machinery and equipment, buildings and real estate, parts and inventory, and any other valuable and valued asset in a company’s possession. The difference between a business’ assets and liabilities, known as “Net Worth”, is also considered capital or equity. Many different items can be included under the umbrella of capital.
Drilling deeper into the subject of capital is the designation of working capital. For most companies, working capital is considered to be the cash on hand for conducting business. Cash is used to pay bills, payroll, and other expenditures required to keep the business operating daily. Because the demand for cash is high in some businesses, keeping cash available in checking and savings accounts for immediate disbursement is one of the most important aspects of a financial manager’s duties. Due to the ever-changing balances in accounts, company accountants are kept busy ensuring there is sufficient cash in the bank to pay the bills. The important question to answer is where does capital come from?
Capital Comes From Many Places
Business 101 reminds us that a company gets money, or capital, from its sales revenue. Whether a business sells products or services, it must generate revenue from the transactions that can be reduced to cash to pay expenses or save. However, there are other places to get “working” capital. For most new businesses, this is a constant activity. Finding, retaining, and paying out the capital requires 24-7-365 effort in most small and medium-sized companies. Large, established businesses also require working capital, also called operating capital, and in some situations, large companies can experience shortfalls in working capital that can cripple the entire organization.
Where Does Working Capital Come From?
As identified above, some working capital can come from sales revenue. Other working capital can come into a company in the form of a loan or an investment by a third party. Banks, finance companies, and other traditional lenders can provide working capital to a business to be used in times when cash is in short supply. Other resources can generate funds used for business operations like the sale of stock shares or receiving funds via a grant. There are also other non-traditional resources for working capital such as Accounts Receivable financing and even credit cards. Suffice it to say that there are many resources for finding working capital. The question is which type of resource is best?
The first source for capital is the money paid into the company from the sale of products, services or both. Invoices are generated to bill a customer for the amount owed as a result of the business conducted. The invoice includes profit that will help with working capital demands in the future as well as income that pays the costs of the services or products provided. The profit portion of the revenue is best allocated to a savings account that can be used later if needed for working capital. Otherwise, profits should be retained as an asset to the company’s Financial Statement Balance Sheet.
Many businesses secure working capital loans from banks to augment their available cash to pay expenses. In some situations, due to cyclical sales processes or market timing issues, sales revenue doesn’t come in regularly and as a result, capital must be increased to cover operating shortfalls in cash. Customers who don’t pay their invoices on time can cause a shortage of cash. Or a company that has to spend additional capital to acquire a new machine or expand its operations may need additional funds. Whatever the reason, a bank loan can help bridge the gap in cash. This form of bank loan is called a Revolving Line of Credit. It is revolving like a revolving door, with money being borrowed from the bank to put into the company’s checking account and then the money is returned when the company gets its expected revenue.
Capital can be generated through the sale of stock shares or the sale of a percentage of ownership in the company. This is considered an investment and can generate substantial amounts of capital. When a company is owned by individual people or a group of individuals, they can sell off a portion of their ownership in exchange for capital. Investors can put capital into a company in one of two ways.
The first way is to provide cash or other capital directly to the company in exchange for an interest or percentage of ownership in the company. The idea is that by investing in the business, the business will grow and expand and earn more revenue and profit. The additional profit can be used to either repay the investor completely with interest on their original investment or the investor can leave the investment in the company and collect a dividend, or a share of the company’s operating profits at a future date. Smart investors manage their funds to take advantage of opportunities to invest in businesses they think will grow and increase the value of their investment.
The second way to obtain capital is to enter into a debt agreement with an investor. In this case, the investor is loaning money to the business but with a combination of potential payouts to repay the debt. Investors can loan money to the company with terms that specify the amount repaid to be a percentage of profits rather than a straight interest-only calculated payment. In other words, an investor can choose to get a percentage of profits that may exceed what they would normally have been paid in interest on the loan. It’s risky, but in the right circumstances, an investor can increase their return on the investment beyond normal interest while still aiding the business by providing working capital.
Debt to Equity Investment
There are many situations where an investor wants to be able to choose whether they want their funds to stay in the business and continue to support working capital needs or they can receive repayment of their funds with interest and not be involved further. These situations are called Debt to Equity investment and an investor can decide which type of relationship will generate better returns. For many businesses, this type of investment is preferred because it gives the company more flexibility for repaying debt.
Receiving a grant is another way to generate working capital. The great part about grants is that they don’t have to be repaid. Grants are capital provided to organizations, businesses, and individuals to help the organization grow and expand to create more economic opportunities. Grants come from federal, state, county, and even municipal offices and are used to accomplish specific goals within the funded organization. Grants also come from private foundations and individuals desirous of assisting companies that work within the grantor’s area of interest. Most grants are provided on a scheduled basis with time required to receive grant applications and review the applications before deciding which company will receive their funds. In other words, grants take time to petition and receive capital from so they are not a good fast-turnaround option for capitalization.
Non-traditional Sources of Working Capital
While most business owners and managers have heard of and probably worked with banks and other more traditional resources for capital, not many business people know about the other ways to generate working funds. There are a few lesser-known, yet equally valuable resources for obtaining working capital. Factors, Lease-back financing, and what are known as Hard money lenders, are three ways to generate working capital that have been around for a long time. Let’s examine each individually.
Factoring – Working Capital From a Centuries-old Resource
Before the Pilgrims landed on Plymouth Rock, factoring had been a financial process in Europe for centuries. Factors would loan money to people and then be repaid when the business sold its products. While the money was on loan, the Factor would hold title to the commodity being financed whether it was cattle, sheep, corn, or barley. In this way, if anything happened to the borrower, the Factor could take the collateral and sell it to repay the debt. In the 21st Century, factoring has come under three different disciplines – Invoice factoring, inventory factoring, and contract factoring. Of course, in modern language, the term used is “financing” and not “factoring”. Each process differs slightly:
- – This is a way to generate working capital by borrowing money against outstanding invoices. Also known as Accounts Receivable financing, this transaction allows a company to receive funds equal to up to 90% of the face value of an invoice while paying a small fee for the use of the funds for the short term they are used. As most invoices are only for a 30-day payment cycle, Accounts Receivable financing is only for short-term capital needs. The company providing the finances is secure because they’re relying on the invoiced company paying the invoice which pays them back. This is an especially valuable resource for new companies that don’t have a credit history or a lot of assets to borrow against. It is the credit rating of the company paying the invoice that is important in this transaction, not the credit rating of the company sending the invoice.
- – When a company holds onto its inventory for a while before it is sold or used in manufacturing, that inventory has asset value while it sits on the shelf. In many situations, the inventory has been paid for while it waits to be used. Borrowing capital and using the inventory as collateral makes sense because it doesn’t seem logical for something that requires cash should tie up the cash a company needs to operate with. Farmers keep their crops stored until the market price is the best for selling but they still need cash to pay bills until that time. Manufacturing companies order, stock, and hold onto inventory until it is needed to go into production and the finished product sits on the shelf until it is sold. There can be a long period where capital has gone out to purchase the inventory and to pay for turning it into a product as well as waiting for it to be sold and delivered to a customer. Company capital needs may not be able to wait that long. Inventory financing is usually transacted with a longer period than Invoice financing.
- – There are many situations where a company has received a contract for a large amount of money but needs the capital to execute on the contract. A manufacturing company can get a contract for $1 million worth of products but need capital to acquire materials, pay labor, and cover other expenses to produce the order under contract. Again, the face value of the contract can be utilized to provide capital. These types of financing arrangements require a better level of confidence in the contractor and the contractee by the funding resource, but it is still a viable means for acquiring working capital.
Lease-back Financing Borrows Capital Against Company Assets
When a company owns machinery and equipment that it uses all the time, the equipment is frequently paid for or paid off and is considered a “capitalized asset”. In other words, the equipment and machinery were paid for with capital and because of that, it has become a capitalized asset of the company. When a company needs working capital it can use the equity value it holds in the equipment and has an independent financing company “lease” the company’s equipment back to the company again. Think of it like selling off an asset and then buying it back again on time with payments. The business receives capital from the leasing company buying the equipment and the leasing company holds title to the equipment for the duration of the lease-back agreement. It’s a simple way to generate needed capital rapidly while allowing for a longer-term payback.
Hard Money Lenders
This is one way to capitalize a business, but it is not recommended. Hard money lenders are exactly what their name says – Hard money. What that means is the terms and conditions of a loan from a Hard Money lender are stringent and risky. Businesses can borrow money but the interest rates are extremely high and the repayment periods are not extendable. In other words, the capital is repaid exactly on time and in full or else the collateral is lost and the debt remains in many cases. While most Hard money lenders consider themselves finance companies, the kind of businesses they tend to loan money to are in a risky position themselves. Many Hard money loans have early repayment penalties specified in their agreements because the lender wants to earn all of the interest on the debt, not just a part of the interest. This resource should be a last resort resource if used at all.
Capitalize With Credit Cards
It sounds funny, but obtaining capital using credit cards isn’t a bad idea for a lot of companies. There are some real advantages to using credit cards that should be understood before passing judgment. If a business doesn’t have much credit history but the owner does, a credit card can be easier to qualify for. Many credit cards come with interest-free inducements and it’s hard to borrow capital interest-free in most situations. Credit cards offer workable repayment terms and can be repaid early without penalties and saving interest. With credit levels at the ten thousand dollars, twenty thousand dollars, or even higher level, In some circumstances, it is easier to get capital from a credit card than it is to get a bank loan.
Cash Flow is King!
Time and time again, the phrase “Cash Flow is King” has been the mantra of many financial managers and accountants. Having the cash or capital available to make ends meet, paying the bills and other expenses is paramount to operating a business successfully. All businesses should be prepared to deal with working capital demands and many financial consultants recommend retaining at least 60 to 90 day’s working capital in the bank at all times. As money flows in and out of a business, maintaining an adequate supply of capital is the #1 priority. Establishing resources ready to step in and provide working capital on short notice is always a good idea and smart business.