What is working capital, and how can you ensure you have enough?

COVID-19-related economic disruptions have served as a powerful reminder to SMEs of the importance of sufficient working capital and cash flow in their businesses over the last 18 months.

If you’re wondering what working capital is, it’s the difference on a company’s balance sheet between current assets and current liabilities (which are short-term obligations). Current assets are anything that a company can convert into cash in the next 12 months. Whereas current liabilities are the costs and expenses it will incur during that time.

Working capital is a solid indicator of a company’s financial health in the short term. It can be used to determine whether a company has enough short-term assets to cover its short-term debt and continue to operate on a day-to-day basis.

Businesses that have physical inventory, such as manufacturers, retailers, and wholesalers, will have larger working capital requirements than others. Seasonal firms or those that are growing rapidly may expect a significant increase in their working capital requirements.

How to assess your own Working Capital requirements

Most organisations prefer a positive working capital ratio, which is calculated by dividing current assets by current liabilities. Most analysts, on the other hand, consider that a decent working capital ratio is between 1.2x and 2.0x, or $2 in current assets for every $1 in current liabilities. If your company’s cash flow goes below this level, you have liquidity issues that may need more financing.

How to increase your Working Capital

You can increase your working capital in a variety of ways. Making sure you’re aware of your cash conversion cycle is a smart place to start. The interval between money going out the door for inventory and money coming back in from sales represents by this cycle. And the faster a corporation can turn this around, the better. There are three main elements, without getting into too much detail:

• A company must reduce the average number of days it takes to sell its inventory, which accelerates the time it takes to receive cash that can be reinvested.
• A firm should reduce the average number of days it takes to collect outstanding invoices/accounts receivables so that cash can be reused sooner.
• A company should increase the average number of days it takes to pay its suppliers/accounts payable which allows the business to hold on to cash longer and utilise it effectively in the business during this timeframe.

The steps above involve effective credit terms negotiation with your customers and suppliers, as monitoring your cash flow may be extremely tough when working with large clients with long payment periods or slow-paying consumers. You might also consider providing early payment incentives, such as a discount off the invoice amount.

Where to go for Working Capital

According to a recent Xero Small Business Insights research, over 60% of SMEs are looking to borrow money, with the majority seeking working capital support. According to the research, the main cause was delayed credit collection terms, especially from large private sector enterprises. It was also shown that the average debtor period is over 50 days and is increasing. According to the survey, nearly half of all SMEs have negative cash flow at some point during the year, with the most of this occurring in the months leading up to Christmas and into January.

Because every SMEs has a transactional bank account, many of them would start by looking at their bank’s options. This could be in the form of a credit line, a line of credit, trade finance, or invoice financing. However, while banks are often the most cost-effective, big banks may be hesitant to give further services in the current atmosphere, particularly without additional security in the form of charges over the firm or a director’s personal property.

A specialised trade finance or invoice finance company could be a solution. In general, trade financing requires security over the company’s or director’s assets, whereas invoice finance requires security over all outstanding invoices. These services will be more expensive than those offered by major banks, but they will still be a solid option.

Businesses must consider all of their alternatives and determine which is the greatest fit for their needs. In some cases, several facilities must be used in tandem to provide the best outcomes. Which of these services is most appropriate may be determined by the source of the cash flow snag. Understanding your specific financial requirements may be difficult at first, but once you understand, it will go a long way toward ensuring that your company works effectively.

Many firms are turning to non-bank lenders to address cash flow issues with an unsecured facility if they are unable to obtain an increase or a facility from their bank or a specialised working capital financier. The main benefit of an unsecured facility is that it can sit alongside other finance facilities (such as a bank or a working capital financier) without causing any issues. Because it is completely unsecured. It also works well as a backup facility and is especially useful for seasonal or growing businesses.

While some of these unsecured facilities can be more expensive, there are still some financiers who offer very reasonable rates, so once a business has been denied an increase or reached the limit of its secured facility, the best way to ensure that they can continue to take advantage of new opportunities – or pay for expenses – as they arise is to add an unsecured facility to run alongside it.