Working capital management
Working capital is the lifeblood of most businesses. Cash is being locked up in working capital to pay for the suppliers during the time the company is transforming the goods or services from the suppliers, delivering those goods or services to the customers and then get paid after the credit terms offered to the customer. Tangible goods are a good example, but services such as software licenses are also to be taken into consideration where long customer payment cycles can be a problem for the company’s finances.
Managing your working capital allows you to increase your cash available and therefore avoid cash flow problems in times of stress such as peak seasons or strong sales growth.
Defining working capital
Working capital is the difference between the current assets and the current liabilities of the firm. Cash is not taken into account in the current assets as it is not part of the amount of money locked up in the company’s operations.
Working Capital = Current Assets – Current Liabilities
The Current Assets are made out of
While the Current Liabilities include
Accounts Payable; and,
Decreasing the Current Assets while increasing the Current Liabilities intelligently without endangering the business is the smartest way to grow your business in a healthy way. In the next section we provide insights on how to manage working capital efficiently.
Financing working capital requirements
Cash is king in financing your working capital requirements. However, keeping on raising equity is not the best way to fund your business when alternative solutions are available. Equally, financing short-term cash requirements with long-term debt collateralised by long-term assets is a cash-trap that will block you from upgrading your assets efficiently when the time comes to invest in new machines, land or buildings. Since Working Capital is made out of Current Assets and Current Liabilities, let’s analyse the Current Assets for which the first item is Accounts Receivable.
Accounts Receivable Financing Used when: you need faster payment for goods and services from your customers
Your accounts receivables represent the unpaid invoices of the goods or services that were sold and therefore represent a future cash flow. Receivable financing is a way to decrease your Working Capital Requirements by having a financier to buy your invoices at a discount. The financier will get paid later when your customer’s credit terms are expiring and the invoice is paid. This process is repeated each time your business generates an invoice that you finance through a financier.
This mitigates the need for your company to collect directly from your clients. It also transfers the risk of non-payment from you, to the financier. For example: Say you have sold custom software to a client. You have accounts receivable for $350,000, for said software. The accounts receivable is payable within 90 days, but you need to pay back the programmers, testers, and coders within the week.
In such a situation, you could sell the accounts receivable to a factoring company (this can be a bank, alternative financier, or private investor), at a slight discount. You could sell the $350,000 accounts receivable at $297,500 (a 15 per cent discount). In most cases you can receive the $297,500 within 24 hours or immediately, as opposed to waiting 90 days for the full amount.
The discount on the accounts receivable varies depending on the financier approached, so business owners must be careful to select the one that best suits their business needs.
Key Benefits for Businesses
#1 Improved cash flow by early settlement of receivables
The most important advantage that receivables financing provides is improved cash flow. By accelerating your revenues, receivables financing helps ensure that you have cash on hand to cover important business expenses, such as payroll and supplier payments.
#2 Flexible financing that smoothens cash flow from new and existing customers
Early settlement of accounts receivable generates cash flows allowing businesses to manage business and growth requirements.
#3 Strengthen your relationship with customers
Receivables financing allows you to enhance your relationship with your customers by offering enhanced credit terms for higher purchases.
#4 Works for the vast majority of businesses
Small and large businesses rely on receivables financing to better manage cash flows and improve customer service.
By implementing a receivables finance programme, a company can benefit tremendously from a decrease in accounts receivable. The benefits are not just on the cash flow of the company, it increases the company’s valuation and it allows to be more flexible in your negotiations with your customers. Having more flexibility in offering longer credit terms to buyers puts you in the driver’s seat to increase your sales and your margins substantially.
- Etienne Van den Bogaert, Head, Receivables & Supply Chain Finance, EFA Group -