Why Working Capital is Crucial for Every Business

Working capital is the lifeblood of every business. Without it as a startup, you won’t be able to pay your people and your suppliers. And even if you’re growing and profitable you could find yourself facing financial disaster.

But what exactly is working capital and what are the consequences of lacking it?

Put simply, working capital is the difference between your current assets and current liabilities. Put another way, it’s the difference between the money you own and the money you owe. In general, the higher the working capital, the healthier the company.

What can you do with working capital?

The simple answer is, almost anything you like. In addition to using it to meet your financial obligations, you can use it to invest in inventory or equipment. Or hire new people to drive the business forward and fund your marketing campaigns. Also, you can use it to meet unexpected bills without having to borrow.

So, what happens when your working capital runs out?

The biggest risk is bankruptcy.

It might sound ridiculous to suggest that profitable, fast-growing businesses are most at risk, but think about it. If you take on a major new customer, you will need to invest in new people, processes, and raw materials to service them. Potentially several months in advance of getting paid.

If you don’t have the successful cashflow to pay your bills in the meantime, you could find yourself caught between a rock and a hard place.

However, even if you can pay your bills, you could still find yourself missing out on other opportunities. For example, if a sudden investment or acquisition opportunity comes along, you can’t pursue it if you can’t afford it.

Similarly, your suppliers may be willing to offer substantial discounts if you can pay quickly. If you don’t have the cash on hand, that’s out of the question.

What’s your working capital trend?

But it’s not just today’s working capital that you need to worry about – you also need to think about tomorrow. That’s why you need to consider the differing amounts of working capital over time, and whether any trends are revealed.

For instance, if you have working capital on hand but it’s less than you had a year ago, this could point to a slow decline in business that you hadn’t noticed.

In simple terms, the less you sell, the less you receive and the less working capital you have. And it’s important to remember that some costs, like rent and business rates, are fixed and will not decline even if your income does.

Similarly, your changing level of working capital can be an indication of the company’s operational efficiency. Money that is tied up in stock too long because your manufacturing process is inefficient, or in unpaid invoices because your credit control is lax, is money that you don’t have. And which should be part of your working capital?

So, what can you do when your working capital is inadequate?

In addition to your Working Capital, you also need to consider your Working Capital Cycle. The Working Capital Cycle (WCC) is basically how long it takes to turn your current assets and current liabilities into cash. So, for example how long it takes from getting in your raw materials to receiving money for your finished product.

Clearly the shorter your WCC the better your financial situation. It is important to realize the difference between getting a sale and receiving the money too.

The longer this period, the greater the cash flow void as you are likely to have had to pay your creditors within 30 days. As the Working Capital Cycle extends the harder you will find it to pay your bills. Whether they be rent, payroll, utility bills, tax, etc.

One solution will be to encourage your customers to pay faster, but this can be much harder than it sounds. Latest figures in the UK from a Dun & Bradstreet survey show that on average an individual SME is owed £64k and Zurich Insurance estimate £44.5 billion as a whole across the country in overdue payments.

In the US the figures are lower but still cause for massive concern with Bibby Finance reporting over a quarter of SMEs not receiving payment within the standard 30 days. The average amount of written off debt is $73k.

If you can’t pay your bills when they fall due, or your project you will be in that situation within a few months, you will need to borrow.

A bank loan or overdraft is certainly one other possibility. Though these have become harder to obtain since the financial crash of 2008. You will probably find more innovative solutions from alternative lenders.

Emergency Loan

If you’re really up against it, the answer is an emergency capital loan. With a streamlined application procedure and minimal paperwork required, the lender should be able to have the funds in your bank account within 24 hours. Potentially saving you from liquidation.

Short-Term Loan

Acting more like a bank loan, a short-term loan will give you the money you need within a few days to a couple of weeks. And is intended to be paid back over a matter of months.

As such, this type of finance is unsuitable for purchasing new equipment that will give you service for many years to come. You’d do better to spread the cost over a longer period.

Merchant Cash Advance

One interesting solution is a merchant cash advance, where you borrow a fixed sum and repay it via a fixed percentage of your daily credit card sales. The advantage is obvious. Unlike a conventional loan, you will never need to make a large payment during a period when business is quiet.

However, there’s a drawback: this is a notoriously expensive way to borrow.

Line of Credit

Acting like an overdraft or flexible mortgage, a business line of credit gives you a limit against which you can borrow and repay at will. As such, this is a great way to solve cash flow issues on an ongoing basis.

You can borrow whenever money is tight and repay whenever business is better. Interest rates tend to be relatively high due to the flexibility. But you will only pay interest when you are using the facility.

Invoice Factoring and Discounting

These innovative solutions can allow you to tame a troublesome cash flow forever by borrowing against the value of your invoices, the instant you issue them.

As the name “invoice discounting” suggests, the finance company will take a portion of the proceeds when your customer pays you in return for providing the facility.

With factoring, the finance company will assign experienced credit control professionals to secure early payment. This will minimize the interest you pay. Whilst with invoice discounting you retain control of your own debtor ledger.

Conclusion

Which solution will better meet your needs will depend on your individual circumstances. Some companies prefer not to have their customers deal with a third party. Whilst others are pleased to outsource collections as it means they don’t need to pay an accounts-receivable team. Or, for very small businesses, distract somebody from a revenue-generating activity.

What is clear is the importance of Working Capital to any business and how you should be continuously measuring it and keeping on top of streamlining your manufacturing processes and chasing late payments to keep on top of it.

More information can be found at this guide to working capital loans.

Carl Faulds
Written by Carl Faulds, Managing Director at Cashsolv providing advice and support to overcome cash flow problems
Carl Faulds

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