Working Capital Finance
This has to be one of the most important types of financing for business owners so this post is quite long. Stay in for the trip though, it could be the key to properly financing your business.
Firstly, let’s define Working Capital so that we can all understand exactly what is being discussed.
Working Capital can be defined as the liquidity available to a business for its operations. For many, this means Current Assets. To make this distinction a little clearer, it is your Cash, Stock and Accounts Receivable. We all assume that both stock and accounts receivables can be converted to cash quickly and as such they are ‘liquid’.
The term Net Working Capital often refers to a calculation that looks like this:
Current Assets Less Current Liabilities = Net Working Capital.
So, how much do you have in liquid assets less how much you owe in the short term – ie. the bills you have to pay soon.
Current Liabilities are made up of items such as Creditors, Short Term Loans and Interest that is due on longer term loans. It is in fact a little deceiving, because if you are discussing real liquidity, then all loan payments should be included within this calculation as well.
Net Working Capital is the amount you have available to you to run your business. You can read more about the effects of shortfalls in Net Working Capital in my article How Increasing Sales Equals Negative Cashflow.
To summarise this article, businesses can find themselves struggling to pay bills when it takes longer to make, deliver and get paid for their products than it does to collect their cash. You know the story, you get paid in 60 days and your bills are due in 30!!!
Some of the options available to businesses are:
- Invoice Discounting
- Invoice Factoring
- Stock Funding
- Purchase Order Finance
- Contract Finance
Overdrafts are often mis-used as a product option by both business owners and their bankers. The reason for this is that neither of the two fully understand the cycle that the business is going through. Equally, it’s very likely that the bank in question does not have an alternative product and as such the Overdraft is used a catch-all solution.
An overdraft is an account that has a defined ‘limit’ attached to it. So, if your limit is $100,000, then you can overdraw your account up to that amount. Just remember, it’s a limit – not a target. Overdrafts are best used in businesses that have stable sales, well defined expenses and fairly predictable collection cycle. From a business owners point of view, they are probably the easiest to use and the cheapest option.
The downside of overdrafts is that they are often linked to a requirement for security. So as the business owner you will be asked to provide your house or other property as collateral for the overdraft. If you don’t have sufficient equity in your property to account for the limit you are requesting, then it could be declined.
The result being that the overdraft is a pretty inflexible beast. If your sales suddenly increase dramatically and you need to access more working capital, you will have to go through the process of applying with your bank and this may mean valuing your properties as well. It could take more time than you have and if you don’t have enough security, it might be a fruitless exercise.
If your business is one that is rapidly growing, or has the potential to (don’t they all?) then you might consider Debtor Finance.
Okay, we have discussed three options so far. Overdraft, Invoice Discounting and Invoice Factoring.
If you are ready for more we can go through Stock Lending, Purchase Order Finance and Contract Finance on the next page.