Every company needs working capital in order to operate. It is used to pay employees, customers and invest in long-term organisational growth. Without it, a business is unlikely to succeed. Yet, many companies focus more on cash flow (which is still important) rather than whether they have the money needed to cover their obligations or invest in new products or services (both of which you use working capital for).
How to calculate your working capital
Working capital is – in effect – the difference between your current assets and current liabilities. Your assets include the money you have in the bank, plus any money you can raise quickly, e.g. by selling stock or equipment.
Your liabilities include any money you owe to creditors that must be paid back within a year. You calculate your working capital by deducting your liabilities from your assets. If you divide your assets by your liabilities, you get your working capital ratio, which should generally be between 1.2 – 2:1.
How much working capital you need to hold back depends on the type of business you operate. For example, companies that operate seasonally, relying on a large volume of sales during holiday periods say, will need a higher level of working capital in order to pay their debts during slow periods.
Why working capital finance is needed
As well as to cover slower periods for seasonal businesses, working capital finance may be required if your company:
- Must pay their debts before you receive payments from customers
- Wants to invest in new products or services that have a significant up-front cost attached
- Needs to cover the cost of an unexpected or one-off project, e.g. professional fees
Working Capital Finance is just one financing option you can choose to cover some/all of these costs. It’s important to make sure you choose the right option for you. For example, if you are looking to purchase expensive machinery, you might want to look at Business Asset Finance (which includes options to lease) or a loan instead.
Forms of working capital finance
Working Capital Finance covers a broad range of lending options, each of which has pros and cons attached:
- Revolving Line of Credit: This is an unsecured form of credit offered by your bank and includes overdrafts. It allows you to access cash quickly and easily to pay bills, including staff salaries and is paid back once you receive payment on outstanding invoices etc.
- Company Credit Card: You may not think of this as Working Capital Finance, but that’s what it is in effect because it allows you to cover the costs of operating your business. Cards might not be suitable for all types of transactions; however, or provide you with the level of funds you need to cover costs.
Credit cards often come with higher interest rates than you would get through other forms of financing so you might want to think of this as a last resort unless you know you’ll be able to pay off any money borrowed quickly.
- Working Capital Loans: These are generally short to medium term loans that allow you to access the cash needed to cover a shortfall in your cash flow, e.g. while you’re waiting for your customers to pay you, or purchase equipment that could improve the profitability of your business.
Most loans will be secured, meaning you will need to use your assets as collateral, which could put them – and your business – at risk if you aren’t able to make repayments.
- Invoice Financing: This allows you to loan money against the value of unpaid invoices (if they are not overdue). Invoice financing is unsecured (the invoices themselves act as collateral) and could allow you to access cash up to 95% of the value of outstanding invoices. The money you then owe is paid back once the customer pays you.
There are several different types of invoice financing depending on your specific needs. You can, for example, borrow money as a one-off against a single or batch of invoices, or set up an account that allows you to submit invoices on a regular/rolling basis, providing you with ongoing access to cash.
- Asset Refinancing: If your business owns equipment or stock, you could refinance these in order to raise funds (very much the way you would remortgage a house). The assets act as collateral, meaning they are at risk if you don’t make repayments.
How much you can borrow depends on the value of your assets, so this option will only work if you have significant stock or valuable equipment that can be refinanced.
- Merchant Cash Advances: If you operate a business that accepts credit cards payments from customers using card terminals, you could apply for a Merchant Cash Advance. This is normally a percentage of the monthly turnover of your business.
This option works well for retailers or the food industry, including cafés, restaurants and pubs.
Getting approved for working capital finance
Just like any other type of finance, you’ll need to get approved for Working Capital Finance in order to take advantage of it. How easy this will be depends on the type of finance you are applying for and how much you are looking to be approved for; generally lenders will only offer you up to 10% of your company’s turnover.
They will also want to see your company accounts, working capital ratio and credit rating before deciding.
If you are a sole trader or partnership, your personal credit rating will likely also be considered as well as that of your business.