The Difference Between Growth Capital and Working Capital

 

Money is vital for any business. Without it, your business is unable to grow from a small operation into something bigger. An understanding of what business capital really is and how it works, along with the difference between growth capital and working capital, is crucial to being a successful entrepreneur.

Outside the banking world, most people are unfamiliar with the differences in types of capital, but as a small business owner it’s necessary that you understand them. A deeper understanding will help as you manage your daily and long term finances, and can greatly affect your chances of getting a loan when you need one.

What Is Working Capital?

Your working capital is the money you need to meet the basic needs of operating your business. These basic needs can include expenses like payroll, inventory purchases, and the carrying of accounts receivable. If you want a credit line for working capital, you’ll need to show how it will be paid through liquidity (i.e. cash), typically over your company’s next operating cycle, which is usually one year.

To determine how well your business is doing when it comes to working capital, you’ll need to know your working capital ratio. That ratio is a great way to see what your company’s financial health is, and it can tell you a lot about the direction your business is taking. The ratio can be determined by dividing your current assets by your current liabilities, which shows you whether you’ll have enough short-term assets to pay any short-term debt your business might have.

Ideally, your total current assets should be higher than your total current liabilities, which would provide you with a positive cash flow and positive working capital. If you have a working capital ratio of 1, that means your current liabilities are equal to your current assets. That is far from an ideal situation, but it is one that is sustainable in the short term, as long as there are no additional liabilities or a loss of assets.

Where companies get into real trouble is having a negative working capital ratio. In that scenario, they have a ratio that is less than 1, meaning the liabilities they are paying out on (or carrying) are costing them more money than the assets they are bringing in (or holding). That position is not a sustainable one, and must be corrected for the company to stay in business and continue to operate. Companies with a working capital ratio of less than 1 can have trouble paying their creditors and may eventually be forced to restructure or close their doors.

However, companies that have a ratio over 2 are also not considered to be doing well. Even though they have plenty of cash flow based on their liabilities, they may be seen as holding onto too many short-term assets and not investing that money back into the company for the long run. When creditors loan to companies, they generally like to see a working capital ratio between 1.2 and 2. A company can increase its working capital ratio by cutting inventory, collecting on accounts receivable, and paying their bills a little more slowly.

What Is Growth Capital?

Growth capital doesn’t relate to the cycle of the business, where money comes in from customers and goes out to pay creditors. That cycle happens fairly quickly, and growth capital is more about the long-term health and well-being of the business. When your business plans to change in a major way, like expanding or adding a new location, growth capital will come into play. It can also be useful when a company merges with or acquires another business. All of these things cost a lot of money, but they’re not constant, cyclical expenses that would be paid with working capital. To cover these large, uncommon costs, your company should build up growth capital over time.

As a company gains more working capital, it can invest that money into the company on a long-term basis. That investment becomes growth capital, and accumulates until the company needs to use it for something. Often, growth capital is used to purchase new and better equipment, or to remodel the building. It can also be used to move to a better location or open a second one. No matter what your growth capital is used for, it should always remain separate from the working capital that is used for day-to-day and cyclical expenses.

Why You Should Always Keep Working Capital and Growth Capital Separate

Often, people who are new to owning and operating small businesses can become confused about working capital and growth capital. Most of the confusion comes from using working capital to fund things that growth capital should have handled. Companies that try to grow and expand too quickly will frequently have this problem, because they use their working capital to develop a new product line or buy expensive equipment. Then they run out of cash that they need to make payroll and pay their creditors.

These business owners find themselves in cash-poor positions that could force them to close their doors, even if they’re actually making a profit. That can be avoided, but only if you pay close attention to your working vs growth capital, and use the right type of capital for the right things. It’s understandable that companies want to grow so they can bring in more money, but the old adage that it takes money to make money really is true. By waiting until growth capital has been built up sufficiently, companies that want to expand see a much higher chance of success.

Companies that have a strong working capital ratio and a good build-up of growth capital will also be much more appealing to creditors. If your company is going to need to borrow money to make an expansion or improvement, having ideal capital ratios and financial strength will make all the difference.

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  1. […] so you can make the right choices for your business. There are two different types of capital: growth capital and working capital, and it’s working capital that will be addressed […]

  2. […] growth capital, that development is certainly possible. Too many business owners fail to understand the difference between working capital and growth capital, which can mean that they don’t spend enough time developing their growth capital the way they […]

  3. […] growth capital, that development is certainly possible. Too many business owners fail to understand the difference between working capital and growth capital, which can mean that they don’t spend enough time developing their growth capital the way […]

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