Working capital, the lifeblood of every business, refers to the difference between a company's current assets and current liabilities. It is a critical measure that provides insight into a company's operational efficiency, liquidity, and short-term financial health.
Global working capital has improved by 9.4% since 2017, so companies are increasingly focusing on working capital optimization. Understanding how to manage working capital effectively can help you secure reliable financing and provide long-term value for your business.
Ecommerce sellers need ample working capital to meet customer demand, particularly during peak seasons. In this guide, you'll learn essential concepts related to working capital and how it impacts your business as an ecommerce seller.
What is working capital?
Working capital is the funds available to an organization for day-to-day operations. Calculate your working capital by subtracting your organization's current liabilities (what you owe in the short term) from your current assets (what you own or can quickly convert to cash).
Positive working capital indicates that a company has enough resources to meet its short-term liabilities, whereas negative working capital suggests potential financial difficulties. Managing working capital efficiently means the company has enough cash flow to continue its operations and grow.
Working capital loans versus traditional loans and lines of credit
Your company's working capital indicates overall operational efficiency and short-term financial health. Businesses that need additional working capital may opt for a working capital loan to cover daily costs or emergencies.
The key difference between working capital loans and traditional loans or lines of credit is their purposes and terms. A traditional loan is borrowed capital that a company must repay under agreed terms. Typically, businesses use them for long-term investments, purchasing equipment, or other substantial operational costs.
For example, a business can get a traditional loan from a financial institution or the Small Business Administration to fund a large one-time purchase or investment. But a line of credit gives them access to revolving capital. They can use a line of credit to make small purchases, repay the loan over time, and then borrow from it again.
While working capital emphasizes liquidity, traditional loans focus on financing long-term growth and larger investments. Businesses must understand this distinction because it will inform their financial strategy and impact overall business health.
Types of working capital
We can categorize working capital into four distinct types depending on purpose.
1. Permanent working capital: This type refers to the minimum amount of working capital a business must maintain at all times to carry out its operations smoothly. It's the base investment in current assets that remains constant regardless of business activity.
2. Temporary working capital: This type fluctuates depending on the business cycle or seasonal trends, and it's also known as "variable working capital." The requirement for working capital may fluctuate during peak seasons and off-peak times.
3. Gross working capital: This type refers to the business's total current assets, including cash, accounts receivables, and inventory. It represents the company's investment in current assets.
4. Net working capital: A company's net working capital is the difference between its current assets and current liabilities. It helps determine whether a business has sufficient short-term assets to cover its short-term debt.
Understanding these types of working capital can help businesses plan their financial strategies more effectively and ensure steady operational flow.
Understanding working capital management
Working capital comprises two main components: assets and liabilities.
Current assets are the resources a business owns or controls and can be easily converted into cash within a year. Current assets include cash and equivalents, accounts receivable, and inventory.
- Cash and cash equivalents: These are the most liquid assets and include currency, bank deposits, and short-term investments that a business can quickly convert to cash.
- Accounts receivable: These are the amounts customers owe to the business for goods or services delivered or used.
- Inventory: This comprises the goods available for sale and raw materials used to produce goods.
Current liabilities are obligations that a business needs to pay within 12 months. Current liabilities include accounts payable, short-term debt, and accrued liabilities.
- Accounts payable: Amounts the business owes suppliers or vendors for goods or services received.
- Short-term debt: Any borrowings or loans the business needs to repay within a year.
- Accrued liabilities: Amounts incurred but not paid.
Working capital is the difference between current assets and current liabilities. An understanding of these components is crucial for managing working capital effectively.
What is the working capital formula?
The working capital formula is a basic arithmetic calculation that derives the working capital by subtracting current liabilities from current assets. It's written as:
Working capital = Current assets - Current liabilities
Calculating working capital is a straightforward process. Follow the steps below to determine your business's working capital.
- Identify your current assets. These include cash, accounts receivable, inventory, and other short-term assets that can be converted into cash within a year.
- Identify your current liabilities. These encompass all debts and financial obligations you need to repay within the next year, including accounts payable, accrued expenses, short-term loans, or any other immediate financial liabilities.
- Subtract your current liabilities from current assets. This is your working capital.
This formula assists businesses in understanding their financial health and liquidity position. A positive result indicates that a company has enough assets to cover its short-term debts, a sign of financial stability. On the contrary, a negative outcome may signal the potential risk of insolvency.
How to calculate working capital
Let's illustrate the working capital calculation with a couple of business examples.
ABC Manufacturing reports the following:
- $500,000 in current assets, with cash being $100,000, accounts receivable being $200,000, and inventory being $200,000.
- $300,000 in current liabilities, with accounts payable being $150,000, short-term loans being $100,000, and accrued expenses being $50,000.
Using the working capital formula (working capital = current assets - current liabilities), we find that ABC Manufacturing has a positive working capital of $200,000, indicating sufficient assets to meet its short-term liabilities.
XYZ Retail Store reports the following:
- $100,000 in current assets, with cash being $20,000, accounts receivable being $30,000, and inventory being $50,000.
- $150,000 in current liabilities, with accounts payable being $75,000, short-term loans being $50,000, and accrued expenses being $25,000.
Using the working capital formula (working capital = current assets - current liabilities), we find that XYZ Retail Store has negative working capital. As a result, it may face liquidity issues or financial distress. It's a sign for the company to take immediate action to improve its working capital.
Is working capital important?
Working capital is paramount for a company's operational sustainability and financial health. It clearly shows the company's short-term financial situation and operational efficiency.
A positive working capital signifies that a company can pay off its short-term liabilities with its short-term assets. And it ensures that a company:
- Has sufficient cash for its day-to-day operations and short-term financial obligations.
- Can take advantage of opportunities in the market.
- Can pay creditors on time.
- Can drive sustainable profitability.
On the other hand, negative working capital may become a problem if it persists, as it says the company needs help managing its finances or may be unable to meet its short-term obligations.
For ecommerce sellers, working capital is key for growth when they need to purchase new inventory and scale their business. A positive working capital balance allows them to buy more products from suppliers, increasing sales and revenue.
What affects working capital?
Working capital can be affected by sales volume, payment terms, credit policies, and business cycles.
- Sales volume: An increase in sales can lead to a greater need for inventory and working capital.
- Creditor or supplier payment terms: The length of your payment terms can affect your ability to pay your bills on time.
- Credit policies: A lenient credit policy may result in more customers owing money to the business, which can increase accounts receivable and working capital.
- Business cycles: Economic fluctuations can also significantly impact working capital. For example, if the economy slows down, businesses may be unable to collect payments from customers promptly, leading to negative working capital.
For companies with limited access to external sources of funds, an effective working capital management strategy is essential for daily operations. Businesses need to monitor their working capital regularly and identify any potential liquidity issues early on to take appropriate measures.
How to improve working capital and cash flow
Ecommerce businesses operate with unique financial dynamics but have several methods to improve their working capital.
- Inventory management: Demand forecasting tools and strategies can accurately predict the need for certain products, reducing the amount of money tied up in unsold inventory.
- Effective receivables management: Employ efficient receivables management strategies, such as offering incentives for early payments, to encourage customers to pay their invoices faster, reducing the accounts receivable cycle.
- Extend payables: Negotiate with suppliers for longer payment terms, so cash remains with you for a longer period, directly improving working capital.
- Dropshipping: Consider a dropshipping model, where you purchase products from a third party that ships directly to the customer, reducing the need to store a larger inventory.
- Leverage technology: Implement integrated financial and sales systems, like accounting automation, to streamline operations related to cash flow, order management, and inventory.
Remember, each business is unique, and what works for one might not work for another. Tailoring these strategies to your business needs is crucial to improving working capital effectively.
How to secure funding for inventory and ecommerce business growth
Working capital isn't always easy to secure, especially for smaller businesses lacking access to traditional financing sources. However, there are several options available that offer specific solutions to meet the business's needs.
- Invoice factoring: Invoice factoring allows businesses to sell unpaid invoices to a third party at a discount.
- Merchant cash advances: Merchant cash advances provide lump-sum payments in exchange for a percentage of future sales.
- Lines of credit: A line of credit gives businesses access to a pre-approved amount of revolving funds.
- Short-term loans: Short-term loans are ideal for businesses needing immediate financing or looking to expand operations in the short term. These loans may come in the form of an inventory loan or working capital loan.
In addition to the above options, businesses can also consider crowdfunding or venture capital investments. Carefully consider the costs and terms associated with each option before deciding.
Fast, easy working capital loans for online businesses through Onramp
Webgility has partnered with Onramp for the perfect solution to help you access working capital loans to help you grow and thrive through the upcoming peak season. Onramp is the only ecommerce-specific cash management solution that customizes your offer and terms based on your sales performance.
You repay your loan when you make sales. Plus, acquiring a working capital loan through Onramp is a secure and hassle-free way to:
- Finance warehouse and working space.
- Invest in materials or product development.
- Purchase inventory or stock up on popular items.
- Update equipment to meet demand.
- Ramp up marketing campaigns and initiatives.
- Get cash in hand in 24 hours.
Onramp's platform analyzes sales data from your Amazon, Walmart, WooCommerce, BigCommerce, or Squarespace storefront to determine your financing eligibility.
And there are no fixed monthly payments or minimums, so you only pay your loan when your customers pay you. With this powerful combination of Webgility and Onramp tailored just for your business, there's no limit to what you can do during peak seasons.