The Black Entrepreneur's Journal - Vol 2

Working Capital: What is it and why is it important to entrepreneurs?

by Michelle Davis

As an entrepreneur who is just getting started, the term working capital may sound like an advanced-level, irrelevant snooze-fest. Your business graduates from start-up websites, grassroots promotions and small investments drawn from discretionary income. It eventually develops into a tangible and profitable product or service. At this stage, working capital becomes more than just savvy business jargon; It becomes a primary driver in making progressive business decisions.

My journey started when I stepped back from my safe, idolized full-time, unionized government job with a pension. I had a great idea and decided I would sacrifice my “job security’’ to venture into the world of entrepreneurship once again. Since my business was a service based platform, in what was a lack of insight, I did not think I needed much working capital to keep me going once I got started. I was wrong! In fact, I was quickly reminded of the reality that “it takes money, to make money!” Working capital is just that. It is the money that you need to continue making money.

Working Capital can be most simply defined as the amount of cash, account receivables, inventory and other liquid assets that a business has available for daily operations after all its current liabilities such as payroll, account payables and other expenses are accounted for. The basic formula to calculate this is:

working capital = current assets – current liabilities.

A healthy working capital ratio for most industries is between 1.2 and 2. The basic formula to calculate the

working capital ratio is:

working capital ratio = current assets/current liabilities

Working capital is often obtained from one of a few sources. Some of these options are best suited for start-ups while others are more relevant to operational businesses:

• Savings/owner’s equity/liquidating personal assets

• Percentage of revenues

(working capital/gross sales x 100)

• Trade or Vendor Credit

• Business Credit Cards

• Business Line of Credit

• Business Loan

• Investors

• Family & Friends

Use discretion when deciding where your working capital source is coming from and do a S.W.A.T. (Strengths, Weaknesses, Opportunities & Threats) analysis at least twice a year. Many business owners are savvy in a specific area of their business, but not all areas. If understanding the financial overview of your business is not your strong point, get support! Access the services of a bookkeeper, accountant or business financial analyst who is good at simplifying details and who will help you review and understand your data.

Now that you understand the basics of working capital and how it is calculated, why is it even important? The money used for working capital is important, because it is the primary asset used to cover the payments and purchases of a business that keep it operational. By effectively managing working capital and maintaining awareness of the ratio, entrepreneurs are empowered to better manage liquidity, improve credit worthiness with lenders/ investors, strengthen the working culture of their team and make stronger decisions for long-term profitability, growth and sustainability.

Having a thorough understanding of your working capital takes time. Businesses are often very cyclical and it can easily take 3-5 years for an entrepreneur to understand their business cycles. When a business owner gets a grasp on their annual projection cycles, and increases their understanding of how the working capital is affected in each cycle; their ability to see the bigger picture of the business elevates. This knowledge enables them to move from working IN their business to working ON their business.

A recent statistic by CBInsights states the top reason Canadian startups failed in 2018 was that 38% ran out of cash/failed to raise new capital. In my entrepreneurial journey I have discovered a commonality amongst many successful business owners who have grown past the startup stage. These businesses have been able to move from idea to reality and onward to profitability and sustainability by engaging onboarding support, such as a bookkeeper, to efficiently manage their working capital at regularly scheduled frequencies (weekly, monthly, quarterly etc).

Having a bookkeeper to reconcile all your incoming and outgoing financial transactions monthly offers an accurate, numerical snapshot of your business health. This skilled management is the quintessential benchmark that will support daily business decisions that lead to sustainability. My favourite book, ‘The Compound Effect’ by Darren Hardy states this principle best. “Small, seemingly insignificant steps completed consistently over time will create a radical difference”. The daily habits of accurately recording each transaction leads to good reporting weekly, then monthly, then quarterly, then yearly. You cannot monitor in your business what you do not actively track in your business. To have an accurate financial snapshot of your working capital year after year, consistent intervals of managing and reconciling are imperative.

Working capital and healthy management of it is a top priority. If the ratio is well managed as a business owner, you can look forward to reaping the benefits. 56% of small businesses apply for funding to expand their business, pursue a new opportunity, or acquire business assets. Prioritize strong working capital in your business and it will put you in a stronger position to capitalize on available funding from a variety of traditional and alternative lenders and propel your business further.

If you cannot answer questions to potential investors or lenders about your working capital, ratios or percentage of revenues dedicated to working capital, start tracking today! Look at your business from the eyes of a prospective lender/investor. Would you want to take a chance on yourself based on your current position? If not, assess your gaps and search out the tools and resources to improve your business financial standing.