Working capital finance

Working capital is what makes your business run. Managed well, it will help improve business efficiency and fuel growth.

It represents the cash a business has after accounting for money coming in and money going out over the next 12 months. In simple accounting terms, this is the net difference between current assets (assets that can be turned into cash within 12 months) and current liabilities (debts or other payable items due for payment within next 12 months) and results in a net positive cash balance or a negative balance.

Working capital differs from the cash flow of a business. Cash flow statements show how much cash is coming in and going out over a period of time. Working capital looks at a broader picture showing how efficiently you are managing the flow of cash through the business. Strong working capital management will enable you to:

• Identify and mitigate against cash flow constraints

• Better utilise idle cash surpluses

• Improve the overall use of capital in the business

Positive or negative working capital

A negative working capital or a working capital ratio (“current ratio”) under 1.0, calculated as current assets divided by current liabilities, might indicate the business has liquidity issues.

A positive net working capital position with a current ratio over 1.0 will indicate the business has enough current assets to secure its immediate/current debt.

However, a business with a current ratio over 2.0 might indicate the business has too high a level of current assets and is not working as efficiently as it could. The right level of working capital will, of course, depend on the business model. For some businesses, operating on a negative working capital basis might be normal. For example, a business like Dell sells stock to consumers before it pays its suppliers for them, creating a negative working capital position despite running efficiently.

Working capital position isn’t the whole story

The short term financial health of a business cannot be simply defined by its net working capital positon alone. Even businesses with positive working capital positions may find themselves in financial trouble if they are unable to pay their creditors as they fall due. This tends to occur when a business is unable to turn it current assets, such as inventory and debtors, into cash quick enough.

The amount of time it takes for a business to turn current assets and current liabilities into cash is known as its working capital cycle. A shorter working capital cycle indicates a business is more efficient whereas a longer working capital cycle means the business has its cash tied up in working capital without earning a return on it.

Monitoring your working capital

As well as the current ratio, many businesses will also look at a number of other ratios to better understand their working capital situation. This includes:

• Quick ratio or acid-test ratio - calculated like the current ratio but excludes less liquid current assets such as inventory and debtors

• Debtor days  - how quickly cash is being collected from customers

• Stock or inventory days - the number of days funds are tied up in inventory; and

• Creditor days - average time it takes a business to settle its debts with trade suppliers

As with all ratios and analysis of the working capital cycle, what is good or bad will depend on the industry, business model and the seasonality you operate within.

You need to monitor metrics over an ongoing period tracking any trend, for example every quarter.

Improving your working capital cycle

It is quite common to see working capital swing from a negative to positive position at different points of a year. Managing those tight liquidity periods, however, requires careful working capital management and reacting swiftly to early signals.

Typical ways to improve the working capital cycle will include the following:

• Credit control  – chase customer debts to be paid quicker

• Supplier relationships – stretching out payments as much as possible without adversely impacting the ongoing supplier relationship. Ideally negotiate better supplier credit terms to avoid being chased

• Inventory controls -  keep inventory and raw material levels to a minimum, as close as can be to a just in time procurement model

• Operational – improve efficiency from processing orders to despatch

• Market  – optimise pricing of product or service to improve demand

Whilst making working capital work as efficiently as possible, it is also important to factor in flexibility to react to more unpredictable events such as cash requirements to:

• Support product launches, for example if an R&D project completes earlier than expected

• Unusually high consumer demand requiring a ramping up of inventory

• Inventory not selling quickly enough to release cash to settle creditors and payroll

External finance needed

Sometimes working capital management alone is not enough to deal with negative working capital and cash shortfalls. In these circumstances, you will need additional financing in order to stave off creditor calls and to keep growth and profitability on track whether that be for purchasing stock upfront at a discount, launching a marketing campaign to drive demand or expanding into new markets.

The two most common financing options to turn to are overdrafts and revolving credit facilities. Let’s consider these both in turn:

Overdraft

An overdraft is normally offered by your bank as part of setting up a current account and is a set credit limit amount that you can withdraw from your account when your account balance is zero. These limits can be authorised with pre-arranged fees and interest or unauthorised where this is unarranged and can become more expensive if regularly used. It can range from a temporary overdraft to handle any cash flow shortfalls to putting in place a short or long term loan.

Pros

• Easy and quick to arrange

• No early repayment penalties/fees

• Flexible terms

Cons

• Variable interest rates

• Expensive particularly if limits are exceeded

• Need to have a current account with provider

• Harder to get large limits agreed

Revolving credit facility (RCF)

Revolving credit is an alternative to an overdraft and normally sourced from another lender. This facility allows you to draw down, pay back any outstanding balance (including interest) and draw down again and again up to a pre-arranged amount (credit limit) for the duration your facility is held. These facilities are often to meet normal expenditure but is also extremely useful to have credit available to pay for large one off expenditure or some unexpected bill or decline in cash inflow.

Lenders look for reliable cash flows and strong financial performance and credit records as well as any assets you hold. The arrangement does not need security in the form of collateral or assets but often you will need to provide a personal guarantee.

Pros

• Quick to arrange and often easier to obtain than an overdraft.

• Fixed interest rates normally

• No early repayment penalties/fees

• Usually pay interest amount drawn down rather than entire credit limit

• Scope to build credit history and increase facility limit

• Not tied into any long term commitment like traditional loans

Cons

• Usually lower credit limit and higher interest rates than traditional loan

• May need to provide a personal guarantee

• Tend to have more restrictions compared to an overdraft

Overdraft or Revolving Credit Facility considerations:

• Don’t just look at the interest rate, other considerations are arrangement fees, security requirements, repayment terms (including minimum repayments) and financial covenant restrictions

• Tax relief is given on repayments lowering the effective interest rate compared to the paper rate given by the lender

• A poor credit rating, typically faced by smaller businesses, may mean higher interest rates are imposed

• Repayments owed to lender ranks ahead of the shareholder

• Ensure you have sufficient operating cash headroom once debt structure is included

• Lenders will typically ask to see the operational model and want to run different sensitives

Alternative sources of working capital finance

Other options that should be considered in addition or instead of an overdraft or revolving credit facility include:

Short term sources:

Invoice factoring (also known as debt factoring)

This is where a debtor (receivables) book is sold, at a discount, to a third party for cash. Factoring does mean loss of control over your credit control function and potential aggressive chasing of invoices of your customers that can damage relationships.

Asset based lending

Loans are provided against specific assets held by the business. The most common form is invoice discounting where the lender provides an advance on customer payments owed to you (debtors). Unlike debt factoring, however, you retain your credit control function and customer relationships.

Asset finance or leasing

A lease is provided to acquire use of new assets or refinance existing assets thereby releasing cash that would otherwise be tied up. A finance lease is where an asset is leased for the majority of its useful life, whereas in an operating lease or hire contract agreement the asset eventually returns the asset back the leasing company (lessor). Leases are typically longer term contracts than bank loans.

Trade finance

Trade finance encompasses a number of financial instruments/products that allow you to trade internationally. It includes issuing letters of credit, lending, bank guarantees, forfaiting, export credit and financing, and factoring. Trade finance reduces risk of currency fluctuations, political instability and non-payment helping improve your working capital position.

Purchase order finance

Once a buyer confirms an order and a purchase order form is supplied, there can be a long lead time from paying suppliers during production process to the buyer paying for the final goods once received. Purchase order finance also known as PO Finance bridges this period which can be a long part of the working capital cycle.

Commercial papers

A commercial paper is an unsecured promissory note (i.e. a promise to pay a specified amount on the maturity date) issued normally by large corporations (with excellent credit ratings) to source funds to meet its short term debts such as payroll.

Merchant cash advance

A provider advances cash on credit and debit card payments from customers helping smooth working capital shortages. Normally there are no fixed repayments and no set timeframe to pay off the loan. The loan is paid off as a percentage of your future card revenues.

Long term sources

Secured or unsecured business loans

Short term or long term loans provided by traditional banks, debt funds or peer-to-peer lending platforms. Term loans are normally cheaper than an overdraft or RCF but are more commonly used to support long term growth plans than as a core working capital finance.

Equity capital

Finance is provided by investors in return for share capital and loan notes. The investors include private equity, venture capital, family offices, high net worth investors and individuals through the equity capital markets (AIM and FTSE on the London Stock Exchange) as well as crowdfunding platforms. Whilst it can be cheaper than debt, it is often harder to secure and means losing some control of your company to outside investors.