Working Capital Financing
by Joseph Lizio - January 18, 2010
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There are many methods to working capital financing; here are a few of the most common:
Trade Credit: The fastest and most efficient way to finance materials or supply is via trade credit. How it works is simple. You purchase goods from your vendors or suppliers. They tell you that you can delay payment for those goods for 60 days. This 60 day period will give your business time to convert those goods, via your operating cycle, into revenue in which to repay the vendor or supplier. If you are not currently getting trade credit terms from your vendors - you might think about asking for them. If you are, you might look into getting them extended. The longer the payment delay terms, the better for your business.
Business Lines of Credit (BLOC): BLOCs are short term revolving credit lines (usually with a 12 month or less term) and are specifically designed for working capital needs. These credit lines allow businesses to purchase needed material, supplies, labor etc., convert those into some form of revenue over a very short period and pay back the borrowed funds as soon as possible. BLOCs are usually revolving lines meaning the business can pay them down from one operating cycles and draw on the line again for another operating cycle. Most BLOCs are set for 12 month periods as these lines are meant for short-term financing only and from a banker's prospective should be paid to zero some time during the business's operating cycle.
Business Cash Advances: These cash advances are not loans but advance against future sales. These advances are great methods of working capital financing as they allow businesses to receive capital up front and pay it back from future sales. Business cash advances are usually based on the total revenue of the business but do require the business to accept credit cards as payments from their customers - as it is these credit cards receipts that are used to pay back the advance. Business Cash Advances are very good working capital products for retail (online and brink and mortar) as well as service businesses.
Accounts Receivable Factoring: Some businesses may find themselves in (according to baseball terms) as pickle - stuck between waiting for customers to pay on one side and having trade partners (vendors and suppliers) demanding payment on the other side. Let's say your business purchases materials Net 10 days - meaning that you have 10 days to pay in full for those materials. You convert those goods into finished products in 5 days and ship them to your customer with a NET 30 day invoice - meaning your customer has 30 days to pay you. In these situations, Accounts Receivable Factoring can be used to obtain the working capital needed to pay off the supplier as well as purchase additional materials for another operating cycle. Then, when payment is received by your customer, the business can repay the Accounts Receivable loan or line of credit and use the remaining gross margin profits to cover other costs and overheads. Most factoring company will advance 80% of the invoice amount and base their approval decisions on your customer's creditworthiness.
(NOTE: it would be financial better, in the long-run, for the business to match its payment days (Net 10) with its collection days (Net 30) by either asking the supplier to extend its payment time or asking the customer to shorten its payment time or visa versa - if possible. This will save the business any and all financing charges associated with this form of working capital financing.)
Purchase Order Financing: Purchase Order Financing is a great method of securing working capital for a business's operating cycle. Let's say that your business has one or more jobs that need to be completed but finds itself without the needed working capital to complete the job(s). A purchase order factor may advance your business the funds (up to 80% of the purchase order amount) so that you can complete the orders, satisfy your customers and earn a profit.
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Lastly, and this cannot be emphasized enough, working capital financing is short-term financing and should only be used for short-term needs. Keep in mind that most operating cycles are very short periods - usually less than 90 days. Thus, any financing to be used in the operating cycles should be short-term. Anything else is bad financial management as the business would be paying far more in interest and fees if it uses long-term financing options for short-term, working capital needs.
There is an old saying that it takes money to make money and in business, especially regarding financing operating cycles, it takes working capital for a business to earn revenue and ultimately earn profits.
Working capital financing is a great means to obtain the money needed to make more money, but if not used properly, can also hinder a business' ability to grow and survive.
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Working Capital Financing - Business Money Today