Working Capital Financing
by Joseph Lizio - January 18, 2010
All businesses have some sort of an operating cycle. This is essentially the time it takes from purchasing needed materials or supplies and converting them into a finished product that can be sold. The operating cycle further consists of selling those products and collecting payment for all that effort. Once products are sold and payments collected, the cycle is completed.
For retail businesses (including online businesses) the cycle starts with purchasing products for resale (inventory) then displaying those products on shelves or on web pages, closing the sale and collecting payment.
Even service businesses, while their operating cycle can be much shorter, still see a time lag between providing the service (to include any purchases of material or labor to complete the job) and collecting payments from customers.
It is because of this time lag that working capital financing comes into play.
All these businesses need some form of assets, be it inventory, materials, supplies, labor, etc. (usually termed: current assets) that can quickly flow through the operating cycle and be converted into cash (revenue). This is essentially what business is. Once payment (revenue) is received, the company can then use any operating cycle profits (gross margin) to cover overhead expenses like salaries, marketing, loan payments and interest, capital purchases, or any fixed general, administration or selling expenses.
The problem that arises for most businesses (especially small and growing businesses) is not having the cash on hand to purchase the needed materials to complete their operating cycle. Not only do some businesses not have the cash or capital to purchase needed materials they may also not be able to cover other variable costs related to the operating cycle like paying labor, landlords, utilities, etc.
In a perfect world, all businesses would have the necessary financial wherewithal to cover all expense while waiting for payment. But, the business world is not perfect. Most businesses have to wait anywhere from one day to years to complete their cycles and get paid by their customers (typical operating cycles usually last from a few weeks to a few months but depend on the industry and business).
But, in the mean time, while these businesses transform goods into finished products or services and wait to be paid by their customers (or wait to see if they can even sell the products or services they offer), their suppliers and vendors, landlords, utility companies, employees, IRS, bankers, etc. all want to be paid now and not wait for the business to receive payments as they are also facing their own time lag in their operating cycles. Thus, for businesses that do not have the cash on hand to meet these expenses, they must turn to working capital financing or face going out of business.
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Working Capital, by definition, is the difference between current assets and current liabilities where current liabilities are used to finance current assets; and the conversion of those current assets into revenue is what is used to pay off those current liabilities.
Example: A manufacture of ball point pens finances the purchase of plastic pellets needed to mold the pen's casings. The manufacture then adds value to this inventory of raw material (pellets) by making the pens and shipping them to a customer. Once payment is received from the customer, the manufacture uses part of this payment to pay off the financier or creditor and keeps the difference to cover its other variable and fixed costs.
Therefore, the manufacture converted these financed raw materials into cash to cover the financing and earn a profit.
The same process can happen in both retail and service businesses as these businesses also need to purchase inventory (stock) to resale or purchase supplies and pay labor to provide a service. But, once the job or sale is completed (after some time lag) and payment is collected, these funds can be used to pay off any needed financing.
As a side note, even if the business does have the wherewithal to cover its current assets from its own retained earning - it might not want to. For one, it is better to purchase an asset that will pay for its self and two, retaining needed cash in a business may have more positive impact if used for growth, expansion, and development - making the business stronger in the long-run.
Continued On Next Page: Common Working Capital Financing
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Working Capital Financing - Business Money Today