Small Business Lending: The Importance of Working Capital
In my last communication regarding the steps to opening a small business, a simple guideline was provided to help you get started in opening a new small business. Once open, the principals of the business have likely injected a significant amount of their own personal cash into the business and, many times, the financing package includes only the loan used to purchase the assets and opening expenses of the business. So, usually the first questions asked at this time are:
1) How much cash do I need in the register to start operating my small business?
2) How do I pay the bills in the first few months until sales pick up?
3) What happens if sales are slow?
4) What happens if sales are greater than I expect?
A key component to the success of a small business is working capital (the level of cash and liquidity in a business). Many times this simple, yet very significant element, is overlooked and not addressed prior to opening a small business. Additionally, businesses need a level of cash, or a source of cash, at all times to manage fluctuations in the sales cycle.
In a perfect world, the small business would sell a level of product and/or service to generate income sufficient enough to cover the cost of producing the product/service. In addition to covering the cost of production, monthly income levels must also cover salaries, operating expenses, loan payments and provide a profit on top as a return for the owner’s investment into the company. However, in almost all small businesses, sales are inconsistent and are not generated exactly as assumed in their original business plan. In some months, sales may be slower than expected and create pressure on the company’s cash to cover all of the expenses and payments in a given month. Also, sales may be very strong and cause pressure on the company’s cash to meet the demand for increased sales opportunities. The company’s ability to manage this fluctuation in sales, either strong or slow, will be the key to the long term viability of the small business. The level and sources of working capital for a small business is what allows the company to “bridge the gap” on cash needs created by this constant ebb and flow of sales.
Permanent Working Capital
You and your banker can, and in every case should, address working capital needs prior to opening a small business. Working capital can be provided by the owner in the form of additional personal cash injected into the company, provided in the financing package by your bank, or a combination of both. As a general rule, the small business needs 90-120 days of working capital in the company’s cash or capital account at the time of opening. This can be calculated by taking the sum of 3-4 months total cash outlay for operating expense, salaries, costs of production and loan payments. If financed, this 90-120 days of working capital should be added to the overall cost associated in opening the business and included as part of the original loan to open the small business. This loan, as mentioned above, is typically paid over a five to ten year basis. This 90-120 days of working capital is now permanently available in the cash account to help reduce the pressure created on “opening day” and the inconsistent nature of the sales cycle. Working capital being injected into the business at opening and financed over a long term repayment plan is referred to as “Permanent Working Capital”.
Short Term Working Capital (Revolving Line of Credit )
Another source of working capital which can provide a small business with a short term solution to the ebbs and flows of the sales cycle is a revolving line of credit. When sales are slow, the small business may need cash to cover operating expenses or payroll until sales increase. Additionally, when sales are robust, the small business may need available cash to increase the level of product or resources to allow for the company to take advantage of increased sales opportunities. The revolving line of credit is a loan which allows the company to advance from the line of credit to provide the cash to “bridge” these temporary fluctuations in sales. Once the sales recover in a slow environment or level out in a robust environment, the advances are repaid. Additionally, since the line is revolving, once the advances are repaid, the line stays in place and is available to advance upon again for the next fluctuation in sales. The small business only pays interest on the line of credit while it is being utilized, unlike that of the permanent working capital source.
Small business owners face so many hurdles and challenges in today’s fast-paced and ever-changing economic and regulatory environment. Taking advantage of the good times or being able to weather the slow times are two areas that small business owners must master. Having the tools to manage the basics of operating a small business is imperative to survival. Working capital is the “life blood” of a small business’ growth and longevity.