Working Capital Finance

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What is working capital finance?

Working capital finance is business finance designed to boost the working capital available to a business. It's often used for specific growth projects, such as taking on a bigger contract or investing in a new market.

Different businesses use working capital finance for a variety of purposes, but the general idea is that using working capital finance frees up cash for growing the business which will be recouped in the short- to medium-term.

There are many different types of lending that could be considered working capital finance. Some are explicitly designed to help working capital (whatever industry you’re in), while others are useful for specific sectors or requirements.

What is working capital?

Definition

Working capital is the amount of cash a business can safely spend. It’s commonly defined as current assets minus current liabilities. Usually working capital is calculated based on cash, assets that can quickly be converted to cash (such as invoices from debtors), and expenses that will be due within a year.

What is the formula for working capital?

For example, if a business has £5,000 in the bank, a customer that owes them £4,000, an invoice from a supplier payable for £2,000, and a VAT bill worth £4,000, its working capital would be £3,000 = (5,000 + 4,000) - (2,000 + 4,000).

Liquid cash

Working capital is seen as ‘working’ because the business can use it — in other words, it’s not tied up in anything long-term. Whether you want to buy stock, invest in the business, or take on a big contract, all of these activities require working capital — cash that’s quickly accessible.

On the other hand, if your business is profitable but has big bills to pay soon, your working capital situation could be worse than it might seem — or could even be negative.

How is working capital financed?

Here are some of the more common types of working capital finance.

Working capital loans

Working capital loans are normally over a short or medium term, designed to boost cash in the business to go after new opportunities. The size of the working capital loan you can get depends on many facets of your business profile.

Secured working capital loans will require assets to use as security, so the amount you can borrow is restricted by the assets available.

Meanwhile, it’s possible to get unsecured business loans up to £250,000 to help with working capital — but for these loans your credit rating will be more important, and you’ll often have to give a personal guarantee.

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Overdrafts

Overdrafts have traditionally been a useful source of working capital finance for many businesses across all sectors, but they're hard to get with a business bank these days. On the alternative finance market there are lots of flexible business overdrafts, which are a great way to finance working capital at short notice when you need it.

The downside of using overdrafts for working capital is that they often have low credit limits, which might limit your plans. They’re effectively a form of unsecured lending, so even if you’re lucky enough to get one, the limit is likely to be fairly low unless your business has a strong history.

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Revolving credit facilities

Similar to overdrafts, revolving credit facilities give you a pre-approved source of funding that you can use when you need. But the key difference is that with a revolving credit facility you don't need a specific bank account with that provider — you can direct the money wherever you need it.

The best part is that with many providers, once they're set up you only pay interest on outstanding funds, which means they can sit idle for a few weeks but are ready to go at a moment's notice. That makes revolving credit facilities a useful safety net to have in place.

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Invoice finance

For businesses that offer credit terms to their customers, invoice finance is a common type of working capital finance. Along with other types of receivables finance, invoice finance is based on money owed to your business, and you normally get a percentage of the value owed via one invoice or the entire debtor book.

Factoring includes credit control, and is often favoured by smaller companies with lower value invoices, whereas discounting and selective invoice finance are other potential options for larger companies with creditworthy customers.

Although invoice finance is a good way of unlocking working capital in the short-term, the amount you borrow is (by definition) limited by the value already owed to you via customer invoices — so it’s not necessarily the right option if you need a more significant amount of money for longer-term growth plans.

Trade finance and supply chain finance

Trade finance and supply chain finance work in a similar way to invoice finance. They’re both types of working capital financing designed for businesses that focus on physical stock rather than services rendered.

Supply chain finance is a mutually beneficial arrangement based on the creditworthiness of buyers, where the buyer can delay payment for longer while the supplier gets payment from the lender immediately (the payment delay is shouldered by the lender, rather than the supplier).

Trade finance is a more complex finance partnership that facilitates international trade, and often involves arrangements like prepayment for the shipment of goods from overseas manufacturers.

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Asset refinancing

If you can’t get enough funding via an unsecured business loan, you can often use assets in your business to raise finance via an asset refinance.

Asset refinancing is based on valuable assets in the business, so you won’t usually be required to offer a personal guarantee or involve your personal home. Like invoice finance, the amount you can borrow depends on the value of the items used to secure funding against.

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Merchant cash advances

If your business accepts payment from customers using card terminals, a merchant cash advance is another useful way to increase working capital. The product gets its name simply because it’s a cash advance for merchants — meaning businesses like retailers, pubs, cafés and restaurants are all suitable.

The amount you get advanced is normally expressed as a percentage of your average monthly card revenue (e.g. 120% of an average month), and critically, repayments are taken as a percentage of future card revenue too. That means repayments can feel relatively painless because they’re taken at the source.

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Tax bill and VAT funding

If you've got a tax bill and it's putting a strain on your working capital, there is funding available specifically designed for paying VAT or corporation tax. Getting a loan for your tax bill allows you to spread the costs over 3-12 months, so you'll have a bit more cash available for other things in your business.

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How is working capital efficiency calculated?

Working capital efficiency is determined using the working capital ratio. This is a business’ current assets divided by its current liabilities. It informs investors and others as to whether the company has the current means to meet its short-term obligations. 

What is a good working capital?

Typically, a working capital ratio between 1.2 and 2.0 is considered satisfactory. A working capital ratio of below 1 suggests potential cash problems.

What happens if working capital is too high?

Higher doesn’t always mean better. For instance, a very high working capital ratio could indicate that a business isn’t investing its surplus capital into its growth, but is instead missing opportunities by letting its cash and assets lay dormant.

Do you want high or low working capital?

Companies should always aim for healthy working capital. A business’ working capital can fluctuate - for instance, it may experience seasonal peaks and dips.

What kinds of businesses require the most working capital?

One company might require more working capital than another because expenses and business needs vary from one industry to another. Take a retail business for instance. It may need a lot of available cash to purchase inventory. A tech company, on the other hand, might not - especially if it operates remotely. 

How do you control working capital?

To help maintain a healthy flow of working capital, businesses can manage inventory effectively, always pay suppliers on time, pay debts on time, fine tune the accounts receivables process and, if needed, consider financing options. 

There are many types of working capital financing available, and choosing the right product depends on your sector and circumstances, as well as what you're trying to achieve. To find out more about working capital financing, browse the related articles below or get in touch.