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Sufficient cash, otherwise known as business capital, is necessary for any business to pay vendors and employees on time and to invest in real and intangible assets that enable growth. That’s why, as a business owner, it’s critical to understand what business capital is, and the differences between growth capital vs working capital.
Business capital is available in two main forms: debt and equity. Debt instruments include term loans and other types of financing which require repayment in the future, usually with interest. Conversely, equity is normally in the form of stock and members or partners’ equity. Equity typically does not require a direct repayment of funds.
In this post, we’ll go into greater detail by discussing growth capital vs working capital, and how each form of business capital may be used most effectively to help a business thrive.
Growth Capital Definition
Growth capital is defined as flexible, long-term debt or equity that is set aside specifically for financing future growth. Growth capital is critical over the long term, and usually accumulates until the business needs it for something – like new equipment, renovations, additional locations (or moving to a bigger or better one), or other major investments and acquisitions. Growth capital can be used for any purpose that supports the growth of the business. It also affords financial stability and flexibility between rounds of financing.
Expansion Phase of the Business Cycle
The business cycle of economic growth and decline happens naturally over time. Each business cycle has four phases: expansion, peak, contraction, and trough. The expansion phase is critical to small business growth and it’s the time during which growth capital is most accessible. Business owners who are able to recognize the phases in a business cycle are better prepared to make good financial decisions regarding their company’s capital needs.
The expansion phase happens between the trough and the peak, and indicates a surge in business activity leading to growth in the economy. This means that the GDP reaches a healthy growth rate of 2-3%, unemployment is at its natural rate of 4.5-5%, and inflation is around the 2% target. When the economy is managed well during this stage, it can remain in expansion for years. The average length of an expansion phase is three to 4 years; however, they have been known to range anywhere from 12 months to more than 10 years.
It’s possible for economists to predict when an expansion is coming. They study indicators such as the availability of cash, interest rates, and the ease with which consumers and businesses are able to obtain loans to determine changes in the business cycle.
An expansion often occurs when the Federal Reserve lowers interest rates and buys back bonds, injecting cash into the financial system. Bondholders then have cash to put in the banks, and then banks have cash to lend to companies looking to expand resulting in low unemployment and increased consumer spending.
This phase comes to an end when the economy “overheats,” or the GDP growth rate surpasses 3%, inflation is greater than 2%, and investors become over-confident. This is how asset bubbles form. They will eventually burst as the economy begins to contract. The final month before the contraction phase begins is called the peak phase.
Equity financing is one option for obtaining growth capital. It refers to the process of raising capital through the sale of shares (or other forms of ownership interest) in a business. Equity financing can be as small as a few thousand dollars raised from friends and family by an entrepreneur or as large as a massive initial public offering (IPO) for billions of dollars from a corporate giant. For our purposes, we’ll focus on equity financing as it applies to entrepreneurs and small business owners.
Equity capital is a popular form of financing for high risk, high return businesses and startups. Often, entrepreneurs will turn to private equity, venture capitalists (and in certain cases, angel investors) in search of funding. Business owners relinquish anywhere from 25 to 75 percent of business ownership in exchange for financing. While equity financing doesn’t require direct repayment of the funds raised, investors are entitled to a share of the profits from the business, depending on their stake. Also keep in mind that if an investor holds voting stock (or rights) they retain certain rights to influence decisions about business operations.
While equity financing relinquishes ownership in exchange for cash, debt financing is the process of borrowing funds to finance your business. This is an alternative form of financing to equity and provides growth capital in the form of loans, credit cards, and other debt instruments.
Although many businesses establish a commercial line of credit (also known as a LOC) with their bank, a LOC typically doesn’t work well for a business when it is in an expansion mode. Lines of credit are meant to serve short-term, working capital needs and is explained below.
Debt financing requires the borrower to repay the funds borrowed in full in a certain time period, and with interest, according to agreed upon terms. The main advantage to debt financing is that the lender does not take an equity interest in your business, and business owners retain full ownership and control.
Keep in mind that in many cases the lender will require your business assets be posted as collateral for the loan and will insist on filing a Federal Uniform Commercial Code form (also known as a UCC-1) at the State’s Corporation Bureau or offices. This notification puts all interested parties on notice that the business has borrowed funds from the lender and the lender has secured a collateralized position against the assets identified in the UCC-1 filing, in case the business defaults on the loan terms.
Regardless of which type of financing you choose, be prepared to produce a solid business plan including financial statements, tax returns, and financial projections. You’ll be hard-pressed to find an investor or lender who will consider funding your business without full disclosure of all financial and tax matters related to the business.
Free Cash Flow Formula
Free cash flow (FCF) is a measure of a company’s financial performance and is calculated as follows:
FCF = Operating Cash Flow – Capital Expenditures
FCF represents the cash generated after a business spends the money required for it to maintain its asset base (like property and equipment). This is important because FCF is the cash available to to enhance shareholder value (or capital growth). It can be used for expansion of the business, reducing debt, paying shareholder dividends or distributions, and a number of other purposes. Increasing free cash flow is a sign of a healthy company and often occurs during the expansion phase of the business cycle.
What is Working Capital
While growth capital is cash specifically allocated for the purpose growing a business and an indication of a company’s long-term growth potential, working capital is a measure of a business’ operating efficiency and short-term financial health.
Working capital can be divided into two categories:
gross working capital (the sum of a company’s total financial resources, or assets); and
net working capital.
Working Capital Ratio
The working capital ratio is calculated as Current Assets divided by Current Liabilities, and indicates whether or not a company has enough short term assets to cover its short term debt. A working capital ratio less than one means the business has negative working capital (or is unable to pay short term debts). Anything greater than two means that the business is probably not investing excess assets (or sitting on too much cash). Most business analysts agree that a ratio between 1.2 and 2.0 is ideal.
Keep in mind that the amount of working capital that is ideal for one company may be different for another. For example, a business that is more cyclical or seasonal will likely want to have a higher working capital ratio than one that sees fairly steady business year-round.
Net Working Capital
Net working capital is calculated by taking a company’s total current assets and subtracting its current liabilities. Working capital includes cash, accounts receivable, accounts payable, inventory, employee salaries, debts due within one year, and other short-term accounts, making it a good indicator of a company’s debt management, inventory management, and revenue collection.
Because net working capital subtracts out all current liabilities, it is a much more thorough and comprehensive view of a company’s financial health than gross working capital.
Working Capital Line of Credit
While it’s always ideal to have enough capital available to finance day-to-day operations, most businesses eventually will face a cash shortage as a result of unforeseen circumstances. In these cases, a working capital line of credit is a good solution. A working capital line of credit is a commitment from a lender or other financial institution to provide cash when needed. In a LOC account, the business may withdraw funds as often as necessary to cover its expenses, payroll and other costs, assuming the maximum committed LOC amount set forth in the Line of Credit Agreement is not exceeded.
A business line of credit differs from a business loan in an important way: interest is not usually charged on the unused funds of a line of credit. Since a business withdraws funds only as needed, interest is only accrued on the funds that are withdrawn.
When cash becomes available to the business, the LOC lender expects the business to pay down the balance owed.
Additionally, the payment terms for a commercial line of credit typically are more lenient than a term loan because normally interest accrued on the LOC is the amount required to be paid. Whereas most term loans require both interest and principle to be paid each month making the payment much larger than an LOC interest-only payment.
Because financial institutions are much more likely to approve your business for a line of credit when you are financially secure, it is generally recommended that you have a business line of credit as a part of your overall financial plan, even if you don’t need one! Doing so will allow the business to access the cash needed when times get tough and maintain normal day-to-day operations.
Working Capital Target
As a business, it is important to have a working capital target, or the amount of working capital you ideally strive to have on hand on an ongoing basis.
A working capital target should be set where it’s possible to maintain sufficient cash to pay for day-to-day expenses and to have some extra to cover unforeseen expenses. Sitting on excessive cash is not ideal and should be redirected or invested for the future growth of the company.
And if your business is for sale and it is sold under an Stock Purchase Agreement, the buyer will usually identify the working capital target it expects the business to have at the time of closing. Buyers may also include in the terms of the stock acquisition agreement a clause which requires an adjustment to the cash to be transferred from the buyer to the seller at the closing should the working capital target fall short.
Growth Capital vs Working Capital Summary
Business owners who understand the various forms of business capital available and when growth capital vs working capital is most appropriate to meet the day-to-day changes in cash availability are better prepared to succeed in the long term.
It’s not unusual for businesses which are fast-growing to run into issues with cash flow and find it difficult to obtain capital. The availability of working capital Lines of Credit from banks depends mostly on how the business has performed in the previous year or two. This means keeping up with the cash requirements to fund payroll and to pay vendors when a business is in a hyper-growth situation can be very difficult.
In such circumstances, growth capital may be necessary — whether it’s from an equity investor or in the form of a term loan from a traditional lender. And in certain cases, considering other alternative forms of capital may be appropriate.
Ideally, understanding the reasons for the cash flow shortages and anticipating what’s going to be happening in the next few years in terms of business growth is wise. Doing so will allow the business owner to have the right type of business capital available to sustain and grow his business.