Working Capital & Funding Options
As most people in business would know, cash is king. No matter how profitable a business is, unless that profit is converted into cash, the business will eventually run out of money. And given the raft of external factors currently impacting trading conditions (supply chain constraints, ballooning electricity prices, tightening of the labor market, and rising interest rates to name a few), the ability of a business to actively manage its working capital is a key ingredient to success.
What is Working Capital?
Working capital is essentially the money (capital) available to meet a business’s current, short-term obligations. i.e. the capital required for the day-to-day operations of a business. For most businesses, there is a delay between when they outlay cash for raw materials, to when they can convert the sale of their products into cash. This is called the working capital ‘gap.’ Unless a business either has a very small working capital gap (or best case none at all) or has sufficient cash reserves to meet the gap, it will require a source of funding to assist with the delay between the outlay of cash and cash collection.
The Working Capital Cycle
The working capital cycle often referred to as the cash conversion cycle, is simply the time it takes for a business to outlay cash for what it produces to the time it collects cash for selling its product. This period is influenced by trading terms (of both suppliers and customers) and the time to convert raw materials into a saleable product (inventory).
How to calculate the Working Capital Cycle
The working capital cycle is calculated by the following formula:
Inventory Days + Accounts Receivable Days – Accounts Payable Days
An illustration of a traditional working capital cycle for a manufacturer, along with a calculation of their working capital cycle, is illustrated below:
The working capital cycle is calculated as per the above formula:
Inventory Days (20 + 15 = 35) + Accounts Receivable Days (45) – Accounts Payable Days (30)
Therefore the manufacturer has to wait 50 days from when they pay for raw materials to when they receive cash from their customers.
How much Working Capital do I need?
The amount of working capital a business requires is calculated by the following formula:
$Inventory + $Accounts Receivable – $Accounts Payable
How do I fund Working Capital?
Working capital can be funded by several different options. Each has different pros and cons. A table is provided below comparing the key features of the four main working capital products available to SME & mid-market businesses (pricing and security are based on reasonable risk spreads and may be larger).
Overdraft / Line of Credit
Overdrafts (attached to a transactional account) or Lines of Credit (managed separately to a transactional account) are the least cumbersome working capital facilities to run. They have no real controls and can be drawn down immediately at the client’s request.
Trade Finance
Trade finance is a facility that can be used to fund stock & inventory and is aligned with your working capital cycle. To draw down on the facility evidence of what the funds are being used for is required to be provided to the financier. This is generally in the form of an invoice or purchase order. The finance is provided for the amount of the invoice over a term aligned to the expected time it takes to convert the raw materials to cash (as determined by the working capital cycle).
Invoice Finance
Invoice finance accelerates the cash collection process by a lender extending a limit against your unpaid invoices. This can be up to as much as 95% of the invoice. You are still in control of the invoice collection and your customers are not advised that a lender is provided finance against the invoice.
Invoice factoring is when your unpaid invoices are on-sold to a third party who then takes responsibility for collecting the outstanding funds. You might choose to use invoice factoring if you want to outsource your debt collection while obtaining immediate funding for the unpaid invoices.
Borrowing Base
Borrowing base facilities are facilities that provide leverage against the assets of the business. The customer borrows against a pool of assets (typically stock & debtors) referred to as the ‘borrowing base.’ The pool of assets can vary from time to time, meaning that the credit will vary by the assets’ value.
Reasons why a business might require additional Working Capital
Each business may require a working capital facility for a slightly different reason but generally, there are a few common underlying reasons for working capital funding. These are:
- A steep growth trajectory with a large working capital gap
- Seasonality in businesses where there are periods of lumpy cash flow
- Change in either creditor (shorter) or debtor (longer) terms which means the business has to outlay cash quicker (creditors) and wait for cash longer (debtors)
- Taking advantage of discounts on bulk purchases
How Nexus Capital Partners can assist with Working Capital
In complex businesses, it can be challenging to see where opportunities exist to release cash from working capital. Understanding where the opportunities sit and unlocking that value can bring huge benefits, from better cash flow to more funds for debt reduction and investment activities.
We look at people, processes, and systems to find and unlock cash and working capital value. We put our “banker hats on” when reviewing a client’s supply chain and working capital cycle and we particularly can add value to high-growth SMEs who may not yet have a strong finance function and finance management team with internal capabilities on how to assess the true funding gap. Put simply, we provide solutions.
Often clients think they need some sort of working capital facility, our competitive advantage of understanding how banks assess true working capital and modeling this for clients is our point of difference.
