BlogFinance
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10
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Written by: 
Nikolaus Hilgenfeldt
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Category:
Finance

What Is Working Capital and Why Is It Important for Online Sellers?

What Is Working Capital and Why Is It Important for Online Sellers?

Working capital is required by all businesses, no matter the industry. However, it is a particularly important concept for e-commerce companies. 

For any business, the working capital they have on hand will help them make informed decisions about their growth strategy and ongoing operations in the next 12 months.

As such, online sellers need to know how to assess their working capital numbers so they can find areas to unlock potential growth opportunities, and secure working capital financing if needed.

Continue reading through this guide as we cover what working capital is, why it’s crucial for an e-commerce business, and when you should pursue getting working capital financing. 

What Is Working Capital?

In simple terms, working capital is the cash balance that shows the difference between current assets and current liabilities. This can be a positive or negative amount, which is a crucial delineation to pay attention to.

With this in mind, working capital signifies the cash you’ll have leftover (or not) after you account for all the money that will be coming in and going out over the coming year. As it were, a positive working capital amount alludes to the fact that you have more short-term assets than liabilities, while a negative balance would mean that you have less coming in than going out. 

How the working capital changes throughout the year can signify how well you’re managing your business, and give you valuable insights on growth opportunities in the near term. 

Working Capital vs Cash Flow

Merchants may wonder how working capital differs from cash flow. Although they may appear similar from the outside, there is an important distinction between the two.

Working capital and cash flow provide different insights about your business. Cash flow will show you how much cash your business brings in during a certain period. Essentially, you see how much cash comes in, and how much goes out.

While this can be helpful, it doesn’t give you any insights into how efficiently you’re managing your cash, or any leeway you have should your sales slow down or your sourcing costs increase in the next 12 months.

Instead, working capital will give you a better picture of the overall management of cash through your e-commerce business, and how you may be able to maneuver through market volatility. Unlike cash flow statements, assessing working capital takes into account your accounts receivable and accounts payable, or money that has yet to come in and debts that still need to be repaid. 

Why Is Working Capital Important?

Working capital is an important component of running an online business. Working capital can help merchants identify any potential bottlenecks before they arise, or recognize idle cash that can be used to fuel further business growth. 

Short-Term Liquidity

At the most basic level, working capital levels will help businesses determine how much short-term liquidity they have, or lack thereof.

If their working capital is too slim, they may not have enough capital to cover short-term cash needs. Having the blank powder to enter new markets or introduce new products could be limited by the amount of capital an e-commerce business has access to. In addition, a pinch on cash levels could keep online sellers from being able to cover bills, pay employees, and other important operational costs. 

Overall, merchants want to have enough liquidity to navigate the ebbs and flows of the business in the short-term, while keeping a focus on long-term growth. In some cases, e-commerce stores will be able to manage their working capital in a way that’s self-sufficient, though many will turn to working capital financing as a way to quickly access the cash they need.

Growth and Investment

Similarly, working capital is an important factor for businesses when it comes to their growth and investment strategy.

Instead of taking the funds from your cash flow, you may choose to secure a cash injection from external financing sources. In doing so, online sellers can capitalize on entering new markets, strengthening their positioning, developing new product lines, and overall promoting a solid growth projection for their business.  

How to Calculate Working Capital

Before an online seller decides to take on working capital financing, it’s helpful to get a good grasp of their current working capital levels to determine what the best solution could be.

The equation to calculate working capital is very straightforward. Total all your current, short-term assets, and subtract the total short-term liabilities from this sum to get your working capital.

Working capital equation

If you’re confused about what constitutes a short-term or current asset, it is any asset that can easily be converted into cash in the next 12 months. Common current assets include: 

  • Inventory
  • Cash balance
  • Accounts receivable
  • Prepaid expenses
  • Short-term investments

On the same note, short-term liabilities are any payables that will be due within the next year. Here are some frequent examples: 

  • Accounts payable
  • Deferred revenue
  • Rent and utilities
  • Materials and supplies
  • Accrued expenses
  • Accrued income taxes

Keep in mind, your working capital can be a positive or negative figure. Positive, of course, is an indication that your capital management is working efficiently, while a negative number could be cause for concern and signal that you need to secure financing to meet short-term cash needs. Even still, this is a very common occurrence among early-stage e-commerce stores. 

Working Capital Ratio

Knowing the cash balance of your business’s working capital is a great measure, though for further analysis we can take a look at the working capital ratio.

This metric has a very similar equation: 

Working capital ratio equation

Generally, this figure will range anywhere from 0.5 - 3, and if there’s more cash coming in than going out, you will have a ratio greater than 1. In comparison, in a situation where there’s more cash going out than coming in, the ratio will be less than 1.

Of course, each of these metrics only shows a snapshot of the business in current times, so there’s plenty of room for working capital numbers to fluctuate from quarter to quarter–or even month to month. Plus, a working capital ratio will look very different for an early-stage e-commerce store compared to one that has a five-year business history.

Regardless, the working capital ratio is a valuable metric that can guide businesses in the short term. Continue reading below as we dive deeper into how you can analyze your company’s working capital ratio to make informed business decisions and gain valuable insights. 

Positive Working Capital 

So what does a positive working capital tell you about your e-commerce business? Again, this means you have more cash coming in than going out and have a working capital ratio greater than 1. You can meet all your short-term debts with the current assets you have, and you may be in a good position to talk with traditional lenders about bringing on additional funding.

This is generally a sign of healthy operations, though you don’t want to end up with a ratio that is too high. For example, if your working capital ratio is above 2, this means you have double the amount of assets than liabilities. While this may appear like a good situation to be in, you need to dig deeper to assess the situation.

If you have low cash levels but a high ratio, this could mean you’re sitting on a lot of inventory, letting receivables sit too long before collection, or paying vendors too quickly. So, even though you have a high ratio, you could easily run out of cash in the coming months.

On the other hand, you may have a high ratio with a high cash balance, in which case it would be a good time for you to invest in your business and focus on growth–like by expanding product lines or investing in new markets. 

Negative Working Capital

Now let’s consider the case where your e-commerce store has negative working capital–or more money going out than coming in and a ratio below 1. Again, you need to investigate further to determine what is causing this and whether you need to secure a financial solution in the near term. 

Among the factors that could be causing your negative working capital, there can be operational bottlenecks that are building up materials, supplies, or deferred revenue, pricing that’s too low, or receivables sitting too long. 

It’s important to keep in mind that many e-commerce stores have seasonal trends, so it may be normal to face a lower ratio when your orders are moving quickly out the door while payables to vendors stack up in the meantime.

Above all, as a business owner, you should monitor your working capital trends to determine whether a negative figure is transitive or prolonged before you begin searching for a solution. 

Working Capital Management for E-Commerce Stores

Consistently, one of the biggest reasons why small businesses fail is due to a lack of capital. As we’ve discussed, businesses need access to cash both to make good on short-term responsibilities and to act on long-term growth strategies.

Especially for an e-commerce store just starting out, figuring out how to effectively manage working capital and ensure that there is consistent funding for operations can be a challenge. 

Even still, there are ways for merchants to improve their working capital levels in a short timeframe through financing, which can help them shoot ahead of the competition and quickly act on growth opportunities.

 

Does Your E-Commerce Business Need Working Capital Financing?

After assessing your business’s working capital levels, you may determine that you have a positive balance. This can indicate you’re managing your cash effectively and are running self-sufficient operations. But, you still may experience a cash pinch in the coming 12 months depending on what’s contributing to this positive figure. 

Negative figures hint at the fact that your business could experience a cash flow shortage in the near term, which could lead to operational chaos.

In either case, many e-commerce stores face negative or fluctuating working capital levels given the nature of the industry. Because of this, it’s common for them to secure external funding to have the security that they’ll be able to cover their short-term responsibilities and turn their focus to long-term growth opportunities.

Here are some common working capital financing options for e-commerce stores: 

  • Revenue-based financing
  • Lines of credit
  • Bank overdrafts
  • Bank loans
  • Merchant cash advance
  • Crowdfunding 
  • Invoice financing 
  • Asset-based financing 

What online sellers use their working capital funding for can vary, though many will use this cash for equipment purchases, hiring efforts, or inventory orders, among other things.

Plus, each financing option will come with its own set of requirements and qualifications, which could exclude certain stores in the earlier stages that have a limited business history or a lack of formal documentation. So, online sellers will need to do their research before pursuing any type of funding to consider the qualification requirements, repayment terms, and how quickly they’ll be able to access the cash. 

Access Asset-Based Working Capital Financing with Myos

For e-commerce businesses that are looking for ways to invest in their inventory and product offerings without having to rely on the working capital or cash flow of their business, many turn to asset-based loans as a solution. 

Merchants like asset-based financing for the flexibility with repayment it provides, in addition to the favorable documentation and business history requirements. Plus, they don’t lose control of their e-commerce store, unlike other financing methods.

What’s more, asset-based finance providers share the risk of the loan with merchants. Instead of putting the personal liability on the online seller, the lender makes its lending decisions based on the products that the business sells, assessing how it will perform in the marketplace and speculating on its future results. 

With Myos, online sellers can apply for funding in just five minutes. Our customers enjoy favorable repayment terms and business history qualifications, in addition to lean documentation requirements and low-risk funding.

Unlock your e-commerce business growth today with asset-based financing from Myos. 

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