Calculate Working Capital for the Self Employed
Are you self-employed? Here’s how to assess your business working capital plan for continued growth.
Running a small business can be demanding, whether you’re a doctor, lawyer, shop owner or freelancer. It can be hard to step back and think about the overall health of your business. But calculating the working capital of your business can make a big difference in discovering how your business is doing and what the next step forward might look like.
Working capital is a common metric used by many companies to measure their financial health. It’s a measure any small business owner can apply. Managing your working capital can keep your business out of the red and ensure you have enough cash on hand to meet any unexpected expenses.
How Much Working Capital Do I Need?
While working capital may be a fairly straightforward calculation for an established business, the same principles apply to your business. Basically, you are adding up your assets and deducting your liabilities. Assets include cash on hand, money owed by customers, and the value of any raw materials and finished products you have in your inventory. You then subtract the expenses, such as the rent, utilities, internet costs, cellphone, and any debts your business may have outstanding.
On the negative side of the equation, don’t forget to calculate all of your upcoming expenses, such as new equipment or property repairs along with big expenses that may only come up once a year, such as malpractice insurance. These can be easy to leave out, as they’re not part of your monthly expenses. And if you plan to take more money out of the business for personal expenses soon, be sure to account for that in your working-capital calculations.
Working Capital for Small Businesses
For smaller businesses and side hustles, working capital can be a little harder to tally up. For one, your personal and business finances may be intermingled.
If you work from home, you may want to find a way to account for the cost of your home office. If you have children, you may want to find a way to account for the amount of money spent on child care that directly supports your business. The same goes for regular bills like electricity, internet, phone, and subscription services.
You’d likely pay for some of those even if you didn’t freelance. So you will have to decide how you want to account for them as a business expense. If you deduct a portion of them on your taxes, then that may be a good guidepost for how you account for them when calculating the business cost of each.
To calculate working capital for a freelance business, you should create a hypothetical salary for yourself if your freelance business is full time, the same way a company includes employee salaries as part of its working-capital calculations. This hypothetical salary is essentially the amount of money you need to make to cover your household or personal expenses with your business. If you’re working part time, then substitute an hourly rate—the amount you need to make for the work to be worthwhile to you. Be sure to include that salary or rate among your expenses for purposes of working capital.
For companies, working capital is usually calculated on a 12-month basis. But for many small businesses, both their costs and their income can be harder to predict, as projects and clients come and go. You may want to try a shorter span, such as six months, when doing your calculations.
No matter how long a period you employ, by being comprehensive in your accounting of expenses and your income, you can get an accurate snapshot of how your business is doing and a better idea of what you should do next.
Positive vs. Negative Working Capital
For companies, a very high working-capital figure isn’t necessarily good news. It can mean that the company is hoarding cash and not investing in new growth opportunities. The same may be true for your business. If you find that you have a very high working-capital figure, it may be time to see about hiring more help, investing in technology, marketing, sales, or other endeavors to expand your business. Or you may just want to give yourself a bonus.
On the other hand, if you find that you have negative working capital, it’s time to ask questions. If negative working capital is part of a broader multi-year strategy, which takes a while for the business to become profitable, then it is important to make sure you have sufficient cash reserves to reach the projected date of profitability.
But if negative working capital isn’t part of your plan, then you may need to cut costs, take on more work, or find another way to meet your needs, such as a loan.
How a Working Capital Loan Works
Companies will often take out working-capital loans such as a line of credit or term loan from Fifth Third Fast Capital to cover their daily operations during periods where they see a drop in income for seasonal or other reasons.
Depending on the structure, size, and track record of your small business, you may be able to obtain a working capital loan as a bridge to get through periods when you may be waiting for a new project to start or just waiting for a payment from an existing client. When working with the government or even large corporations, there can sometimes be a painfully long gap between the signing of a contract and the delivery of the first check. Or if you’re a doctor paid by insurance companies, then the wait to be paid can be lengthy.
For a working-capital loan, you might need to show the lender a current business plan, three years of tax returns, and the past year’s financial statement if you don’t use Fifth Third’s Fast Capital, which requires only three months of bank statements. Depending on the structure, size, and track record of your small business, you may also have to show signed contracts, letters of intent, franchising agreements, incorporation filings, or lease agreements.
But if you’re a smaller operation or a freelancer and you have a short-term working-capital shortfall, then you may want to take a simpler route with a cash advance. These advances are usually for smaller amounts than a working-capital loan, but they can help fill the cash-flow gaps on your spreadsheet.
You may also be in a position where you have healthy cash flow, but there’s an opportunity knocking on your door. Then a working-capital loan or cash advance can help you take the next steps—such as buying a new piece of equipment, attending a conference, or making an on-site visit with a client—to win new business.
No matter what lending route you take, however, be sure to incorporate the interest costs of a working-capital loan or cash advance into the expense side of your working-capital ledger going forward.
Working capital can be a valuable tool for understanding the financial health of your small business. And once you’ve calculated it, take the opportunity to look ahead and take advantage of the financial tools available to you to continue to grow your business.
For more information about working capital for the self-employed, please contact a Fifth Third Business Banking Relationship Manager here.