Working Capital Financing for business
Before we begin, let us first ask the question: What is working capital?
Working capital is the capital of a business which is used in the day to day operations of the business. It is derived by summing your current assets which may include inventory, receivables, prepayments, cash at hand and cash in the bank. Thereafter, you sum up your current liabilities too. This may include payables, accrued expenses, bank overdrafts, current maturities of long term debts, interest payables and more. Then you subtract the current liabilities from the current assets to get your working capital.
In other words, working capital is simply Current assets – Current Liabilities.
Working capital can be further divided into two views, which are the balance sheet view and the operating cycle view.
- Balance sheet view: The balance sheet view divides working capital into gross working capital and net working capital.
- Operating Cycle View: The operating cycle view divides working capital into permanent working capital and temporary working capital.
Let us now take a quick look at each of the subdivisions
- Gross working Capital: From our earlier explanation, to derive the working capital we subtracted current liabilities from current assets; this gives us the net working capital. The gross working capital would simply be the current assets only, without subtracting the current liabilities. Current assets are short term assets which are liquid and can easily be converted into cash within a period of one year or less. The problem though is that not all the current assets may be readily converted into cash. For example inventories may not be easily sold, and receivables may fail to pay up within a year .
- Net Working Capital: Net working capital is the difference between the current assets and current liabilities of a business. Net working Capital measures efficiency and a company’s short term financial health. Although it is safe for a company to have a working capital of 1 or greater than 1, a working capital that is too high is also unsafe for business. It connotes inefficiency in operations; it indicates that there is either too much cash tied up in inventories or that the company is not investing excess cash. Therefore, a high working capital ratio is not necessarily the best. Also, a company can be at risk of a bankruptcy if the working capital is too low and the company runs into trouble in paying back creditors in the short term.
- Permanent Working Capital: A permanent working capital is the minimum amount of working capital necessary to maintain the circulation of the current assets. Permanent working capital is further divided into two, which are:
- Regular Working Capital: This is the permanent working capital required at all times to keep smooth the flow of working capital. It is the minimum amount of liquid cash that is required to keep up the circulation of capital from cash to inventories and back to cash.
- Reserve Working Capital: This is a contingency working capital. It is kept over and above the regular working capital in case of unforeseen or extraordinary situations.
- Temporary Working capital: This is the difference between net working capital and permanent working capital. Ie Temporary working capital= Networking capital – Permanent Working Capital. Temporary working capital is also called variable working capital because it fluctuates, meaning that it cannot be forecasted. The temporary working capital can further be divided into:
- Seasonal Working Capital: Because of seasonal changes in the environment, a product might reach its peak at a particular time period. The seasonal working capital is then the liquid capital needed for that particular season.
- Special Working Capital: Special working capital is the extra working capital needed to finance special operations. Special working capital cannot be forecasted, they are mostly one-off events that rarely occur. For example the execution of special orders of the government.
Using existing working capital as a source of obtaining finance
- Selling outstanding receivables: Outstanding receivables are money not yet collected for goods sold on credit . It means that goods were sold or services rendered on credit to the purchaser who becomes a debtor or account receivable. If you account receivable (debtor) has a high credit rating with high probability of repayment, you can borrow some money or take a business loan and sell the outstanding receivables to the lender.
- Sales and lease backs: This is when you sell your equipment or machinery to a buyer in exchange for cash. You then enter a lease agreement and lease it back from the buyer for a monthly payment. At the end of the lease, your company repossesses the machinery or equipment.
- Credit card receipt advances: This is a type of loan where payments are made from your future credit card receipts. Here you get capital for your business from a receipt advance lender, and they take a certain percentage out of each of your future credit card sales until the principal is exhausted.
If you are looking to start a business, why not check out how to go about writing your business plan