You may be familiar with the term ‘working capital,’ but what does it really mean, and how can it impact your business’s financial stability?
In brief, ‘working capital’ is a financial metric that reflects a company’s operational efficiency and short-term financial health.
Sufficient working capital is crucial for any business to maintain operations and grow revenue. However, not every business has the necessary funds available to cover these costs at any point in time – and that’s where working capital finance can prove an effective solution.
Let’s delve into the intricacies of working capital and explore the potential benefits and drawbacks of working capital financing.
What is Working Capital?
‘Working capital’ is essentially the amount of money a business has available to cover its day-to-day operating expenses.
In simple terms, it refers to the difference between a business’s current assets and current liabilities.
The primary purpose of working capital is to provide the necessary funds for routine procedures, such as paying employee salaries, purchasing raw materials, and meeting other short-term financial obligations.
By analysing their working capital, business owners can determine their short-term financial stability and operational proficiency. It is vital to closely monitor your working capital, to ensure that the business has sufficient liquidity to function smoothly and avoid financial distress.
How to Calculate Working Capital
Working capital can be calculated using this simple formula:
Current Assets – Current Liabilities = Working Capital
Current assets refer to cash and anything that can be converted into cash within a year. These can include raw materials, accounts receivable, inventory, stocks, and bonds.
Current liabilities include all bills which are due to be paid within a year, such as accounts payable, payroll, tax, and overheads.
A positive working capital indicates that a company has enough assets to cover its short-term liabilities, whereas a negative working capital implies potential financial trouble as the business might struggle to meet its short-term obligations.
How to Manage Your Working Capital
Managing your working capital is key to maintaining your business’s financial and operational stability.
Here are some strategies to help to improve your working capital management:
1. Cash flow forecasting:
- Create regular cash flow projections.
- Update forecasts with actual data.
- Identify potential cash flow gaps.
2. Efficient inventory management:
- Review inventory levels frequently.
- Balance stock holding costs wiht stockout risks.
- Use effective inventory management techniques.
3. Optimise accounts receivable:
- Establish clear credit policies.
- Offer early payment discounts.
- Follow up on overdue invoices promptly.
- Regularly review customer credit scores.
4. Extend accounts payable:
- Negotiate favourable payment terms with suppliers.
- Take advantage of early payment discounts.
- Use electronic payments for better tracking and control.
5. Improve sales and collection cycles:
- Streamline the sales process to minimise order-to-cash cycle time.
- Implement automated invoicing and payment processing systems.
6. Maintain a cash reserve:
- Set aside funds for unexpected expenses or opportunities.
- Establish a line of credit as a safety net.
7. Monitor financial ratios:
- Regularly review key financial ratios (e.g. current ratio, quick ratio).
- Benchmark against industry standards.
8. Prioritise investments:
- Evaluate capital expenditures carefully.
- Focus on investments with high ROI and short payback periods.
9. Optimise expenses:
- Review and control overhead costs.
- Identify areas for cost-saving opportunities.
10. Seek professional advice:
- Consult with financial advisors, accountants, or commercial finance brokers for guidance on how to forecast and improve your working capital.
How to Raise Working Capital Finance
Financing working capital involves acquiring funds to support the daily operational expenses of a business. It ensures the smooth functioning of business activities and helps to maintain adequate liquidity.
This type of financing is a valuable tool for companies that face temporary cash flow challenges, or require additional funds for expansion.
Unlike other types of loans – such as equipment loans or commercial property loans – working capital financing does not have a specific purpose. It is more generic in nature and can be used for any running costs the business needs to cover.
The most common methods of raising working capital finance include:
- Borrowing money from banks, credit unions, and other financial institutions.
- Securing venture capital funding.
- Raising equity investment.
- Borrowing money from family or friends.
Types of Working Capital Finance
The financing of working capital is a multi-faceted, complex solution, and there are several loan and line of credit options to consider, including:
- Working capital loans: The loan amount and terms will vary depending on both the lender and the financial needs of the business, but these are generally short-term business loans with a repayment schedule ranging from 3 months to a year. The loan can be secured or unsecured and will usually have a fixed interest rate with monthly or bi-weekly payment terms.
- Bank overdrafts: A short-term financing option offered by banks, overdrafts allow businesses to withdraw more money than is available in their account, up to an agreed limit. They offer flexibility in accessing funds and can be used as needed.
- Line of credit: A revolving line of credit allows businesses to borrow funds up to a predetermined limit and repay the borrowed amount with interest.
- Asset-based lending: This is when a loan is secured against business assets, such as inventory or equipment. It offers a higher borrowing limit compared to unsecured loan and can be tailored to meet the specific working capital needs of a business.
- Trade credit: This is offered by suppliers as a credit period for payments. It helps in managing cash flow by allowing the purchase of inventory or services on credit. Negotiating favourable terms with suppliers can result in extended credit periods or discounts.
- Invoice factoring: Invoice factoring involves selling outstanding invoices to a third party at a discount to receive immediate cash. The third party, known as a factor, takes responsibility for collecting the receivables.
- Invoice Discounting: This is similar to factoring, but the business retains control of collecting the receivables. The lender advances a percentage of the invoice value and the business receives the remaining amount, minus fees, after collecting the receivable from the customer.
- Trade finance: ‘Trade finance’ refers to financial instruments and products that facilitate international trade transactions. It includes letters of credit, export financing, and supply chain financing. It can assist in managing the risks associated with cross-border transactions and currency fluctuations.
Benefits of Financing Working Capital
- Enhanced liquidity: Working capital finance can help businesses address short-term cash flow issues and maintain financial stability, by providing a cushion for operational expenses (particularly during periods of seasonal fluctuations or unexpected downturns).
- Opportunity capitalisation: With additional working capital, businesses can seize growth opportunities, such as investing in new projects or scaling up production.
- Flexibility: Unlike other types of loans which have specific purposes, working capital finance can be used to cover any operational expenses. Also, with a variety of financing options available, you can likely find a solution which aligns with your specific needs.
Drawbacks of Financing Working Capital
While working capital financing can be beneficial, it also comes with potential drawbacks that businesses need to consider:
- High interest rates: The interest on working capital finance in Australia is typically higher than that for other loan types. This is due to the short-term nature and the higher risk associated with lending – and can result in a significant increase in the overall cost of borrowing.
- Short repayment terms: Working capital financing is usually a short-term loan which must be repaid within a year or under. While this can be beneficial in that you’re not locked-in for an extended period, it can put a strain on a business’s cash flow, as you will need to make regular loan payments while still covering your daily running costs.
- Strict eligibility criteria: Lenders may have strict eligibility criteria that a business must meet to qualify for working capital finance. This can include minimum revenue requirements, credit score thresholds, and other financial metrics. It may therefore be difficult for some businesses to access the financing they need.
- Debt accumulation: If not managed properly, businesses might accumulate debt that could put a strain on future operations and profitability.
Is Working Capital Finance Right for You?
Working capital is a key component of managing the financial health of your business.
While working capital financing can provide a lifeline in certain situations, it’s also imperative to carefully evaluate the potential drawbacks. Any source of financing must be approached with a clear strategy and a solid understanding of your financial position and capabilities.
How to Finance Working Capital with Ledge
Ledge Finance are one of Australia’s most trusted commercial finance brokers. Our experienced team are on hand to help you source the best finance solution for your unique requirements. Contact us today for further information.