What You Need To Know About Working Capital Finance
The working capital of a business is the difference between its current assets and current liabilities. On the one hand, current assets include all such things as raw materials in stock, finished goods as well as work in progress. It also includes trade receivables, short-term investments, and raw cash. On the other hand, current liabilities include such items as trade payables (for example money that is due to be paid to suppliers of raw materials), overdraft and short-term loans. Businesses, however, will often need to obtain working capital finance for a number of reasons which shall be discussed. Suffice it to say for now that for businesses to continue to exist, they must be able to generate adequate cash to meet their short-term obligations. This implies that the current assets of a business must exceed current liabilities, ensuring that the business remains solvent depending on the nature of current assets involved in the business.
Importance of Having a Working Capital Management Policy
Because of how much important the issue of working capital is to the success of a business, it is important that businesses evolve methods of managing their working capital. Managing working capital will, as a matter of fact, involve formulating clear policies on working capital which could either be aggressive, conservative, or moderate, depending on what is deemed to be favorable to the business. Proper working capital management will also enable a business to determine what form of working capital finance it can obtain. Policies pertaining to working capital management regardless of whether it is aggressive or conservative are all aimed at determining the level of investment in working capital for a given level of operation as well as the extent to which short-term funding is used to finance working capital. These policies are employed to manage inventory, short-term investments, and trade receivables.
Understanding the Kind of Working Capital Policies a Business Might Adopt
Let us take a closer look at the kind of working capital policies a business might employ in order to determine the form of working capital finance it is to adopt. First, an aggressive policy regarding the level of investment in working capital will cause a firm to operate with the minimum level of inventory, cash as well as trade receivables for a given level of business activity or sale. The rationale behind adopting an aggressive policy is that such a policy tends to increase the profitability of a business in that cash is tied up unnecessarily in current assets. However, a business which adopts an aggressive policy runs the risk of having cash shortages or even running out of inventory if, for instance, sales suddenly increase.
A conservative policy on working capital management often ensures a large cash balance is obtained. Being that a conservative policy is more flexible, a business might find itself investing in short-term securities, retaining a much higher level of inventory as compared to a business which adopts an aggressive policy, and even offering more robust credits to customers. Although this kind of policy reduces the risk of cash flow problems, it, however, diminishes the profitability of the business. The last kind of policy which a firm might adopt on working capital, moderate policy, is often a good compromise between the extremes of the aggressive and conservative policies. A moderate policy, therefore, will keep an optimal balance of inventory, cash and trade receivables for a given level of business activity. Before looking at the options available to businesses seeking to obtain working capital finance, let us take a look at some of the major internal factors that influence the working capital decision of firms.
Internal Factors Influencing Working Capital Decisions of a Business
One of the foremost factors which influence the working capital decision of a business is the nature and size of the business itself. Let us assume for now that size refers to the scale of operations of the business. In this regard, a business that has a larger scale of operation will typically require larger working capital that a business which operates on a smaller scale. In the same vein, the nature of the business will also play a major role in helping the firm make a decision on working capital, particularly in the area of obtaining working capital finance. For example, trading businesses such as retail stores as well as financial firms which invest less in fixed assets are continually in need of working capital much more than public utilities which primarily invest in fixed assets.
The production cycle of the business, that is, the period from when the raw material required for the manufacture of a particular product is purchased to when the intended product is finished—assuming the business is a manufacturing one—plays a crucial role in determining how much working the business is going to require. If for example, the production policy of the business is of the uniform type then the larger the production cycle the larger the amount of working capital the business will require, and conversely. In addition, the credit policy of a business also plays an important role in how much working capital it needs as well as the form of working capital finance that best suits it. A business which is liberal in credit policy to all of its customers would naturally require higher working capital than a business which is very strict when it comes to the issue of credit. A firm that has a strict credit policy will often not grant credit to customers; at best it might grant credit facilities to just a few.
In a quite similar vein, a firm requires less working capital if it has ready access to credit facility which is issued to it on favorable terms. If a business gets good credit terms from its creditors such as suppliers, then it will generally be more practical to run the business with less working capital than would be normally possible. A business, on the other hand, which no access to bank credit will often require more working capital to run and this would invariably affect the nature of working capital finance it can utilize.
How rapidly a business is growing stands to impact on the amount of working capital it requires for good reason. A rapidly growing firm will regularly need funds to invest certain fixed assets that will enable it to expand its production capacity in order to meet with increasing sales. The profit margin and dividend policy of a business also determine the magnitude of working capital it requires as well as the kind of working capital finance option it can utilize. If a business has a high net profit in cash then it boosts the available working capital reducing the amount of working capital the business might need from external sources. But if the business distributes a huge part of this cash profit as cash dividends the working capital would be depleted, increasing the working capital required by the business.
Some of the Major Sources of Working Capital Finance
A bank overdraft is one of the commonest methods of obtaining working capital finance. A bank is simply an agreement between a business and a commercial bank where the latter agrees that the business can borrow up to a certain limit whenever it needs to without consulting the bank any further. One good thing about a bank overdraft is that interest is only charged on the amount the business borrows and not on the amount it can borrow and at a variable rate. It might be required for the business to provide collateral before it can obtain working capital and this might sometimes serve as a discouragement.
A short-term loan is a fixed amount of money which a business borrows from a commercial bank in order to obtain working capital finance and is often repaid within a short period. The business is made to pay a fixed or variable interest on the total amount borrowed until the debt is redeemed. Just as it is with an overdraft, collateral might be required before a short-term loan is issued to a business by a commercial bank. It must be said that obtaining a short-term loan is quite difficult for small businesses because they are mostly unable to meet the demands of banks.
Obtaining working capital finance via trade credit is quite a common practice amongst businesses. Trade credit is an agreement in which a supplier allows a business make payment for goods and services at a later date. It is quite possible for a business to get 2 to 4 months of trade credit in which case it pays for goods 2 to 4 months after the date of purchase. The significance of a trade credit lies in the fact that it allows cash to stay longer with the business thereby providing a source of working capital for the period it is granted.
Merchant Cash Advance
Small business owners have found that the easiest and surest means of obtaining working capital finance is merchant cash advance. In simple terms merchant cash advance involves a business obtaining a lump sum of cash in exchange for its future credit card sales. Technically speaking a merchant cash advance is not a loan and does not operate as one. In merchant cash advance transactions there are no fixed terms—no fixed payment period. Furthermore, collateral is not required nor is interest charged. What happens is that the amount advanced to the business is factored and a fixed portion of the daily credit sales of the business is committed to paying the advance until it is completed. Merchant cash advance, although more expensive than the other sources of working capital finance, is preferable because of the speed with which it can be obtained and because the business assumes no risk in doing so. Indeed, much can be said in the favor of merchant cash advance and it is for this reason that its popularity has been growing among business owners.
Short term sources of financing are known to be cheaper and more flexible than long-term ones. However, the risk assumed (except in merchant cash advance) is much higher and short-term financing might also not be renewed. Of course, a business is expected to strike a balance between profitability and risk; in doing so it is likely to find that obtaining working capital finance through merchant cash advance is the best option suited to the needs of small businesses.
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