Your essential guide to working capital finance
Is your business seasonal and sees cyclical dips in revenue? Do you need a quick cash infusion to cover payroll or rent until your invoices are paid? If yes, then working capital financing is the right option for you. But let’s cover some basic notions first:
Table of contents
What is net working capital?
Working capital or net working capital is a metric for a company to assess its financial condition. It is the amount of cash and liquid assets like inventories and accounts receivable that a business has after it has accounted for its liabilities. It is used to meet everyday financial obligations that a business incurs, like paying salaries, rent, suppliers, interest, and short-term debt payments. If your current liabilities surpass the value of your company’s current assets, you will have negative working capital.
What are current assets?
A company’s current assets are assets that can be used or converted into cash within a year.
These include:
Cash in the bank
Inventory and supplies
Investments that can be converted into cash, like government bonds
Accounts receivable
Short-term investments
What are current liabilities?
On a company's balance sheet, current liabilities are financial obligations that must be paid in the short-term or within the next year. These include:
Accounts payable
Taxes payable
Short-term debt
Rent and bills
Salaries and bonuses
Dividends payable
How to calculate working capital
You can calculate your company's net working capital by subtracting your current liabilities from your current assets. If the resulting number is positive, it means you have the cash to cover your short-term expenses. You may need to reach out to lenders for a working capital loan or other financing solutions for additional funds if it isn't.
Working capital formula
Working capital = Current assets – Current liabilities
Let's take an example. If your company's total current assets amount to £500K, and your total liabilities are £300K, your company's working capital is £200K.
What is working capital ratio?
Working capital ratio is a metric to determine a company's liquidity and its ability to meet short-term obligations. It is calculated by dividing the company’s current assets by current liabilities. A ratio of 1.2:2 is considered good for businesses.
A good working capital ratio indicates that the company is well-positioned to meet its liabilities, but a very high ratio can mean that it is not utilising its current assets well.
What is working capital management?
Working capital management is a business strategy that helps a company effectively manage sufficient cash flow for daily operations and meet its short-term goals and current liabilities. If your business manages working capital effectively, you can unlock liquidity to expand your business, invest in technology, and reduce the need for borrowing.
An important consideration for effective working capital management is that it should cover both planned and unplanned costs, so your company is protected even in a tough business environment.
What is working capital finance?
Working capital financing is a type of funding that companies can use for their short-term cash needs and day-to-day operations. It could be used for payroll, rent, buying raw materials, or sales and marketing.
Types of working capital financing
Here are some working capital financing solutions available for your business:
Working capital loans
Working capital loans help businesses meet their immediate money needs and fill in funding gaps. These are short-term loans that can be used if your business faces seasonal dips in revenue or to cover salaries or rent. Working capital loans can be especially helpful for business owners who don't want equity funding and don’t want to give up company control. Working capital loans are both secured and unsecured, but it is easier for businesses with a good credit score to get an unsecured loan.
Business line of credit
This is a revolving loan that doesn’t need to be secured. A business line of credit is similar to business credit cards; it will let you borrow money up to a certain limit, and you are charged interest only for the amount of money you borrow. This is a popular option with small businesses looking for a flexible option to boost their short-term financial health.
Invoice factoring
Invoice factoring or debt factoring entails selling your company's outstanding invoices to a third-party funder at a discounted price for a quick cash injection. The financing partner collects payments directly from the customers.
Supply chain finance
Supply chain finance is a form of financing that allows suppliers to receive early payments on their invoices from a third-party financer. In supply chain finance, a buyer approves a supplier's invoice for financing by a third-party lender like a bank. This helps the supplier get paid quickly and the buyer to have extended payment terms, unlocking cash flow for both the parties involved.
Merchant cash advance
A merchant cash advance allows your business to borrow against your credit and debit card sales, which are deposited into your business account. It is a form of unsecured funding that allows small and medium companies to access cash fast without going through the traditional business loan application.
Asset refinancing
Asset refinancing is a way to borrow funds against fixed assets owned by your business. It is easy to obtain as the lender has additional security in the form of your company's assets.
Overdraft
An overdraft is a finance facility that allows you to make a purchase or a withdrawal even if you don't have sufficient funds in your business account. The bank allows this facility up to an approved overdraft limit.
How can I get working capital financing?
Qualifying for a working capital line of credit
Minimum requirements for a business line of credit vary from lender to lender, but there are some basic criteria that most funders will require your company to fulfil. These are:
You should have a minimum credit score of 600 or above.
Your business should have been in operation for six months or more. Some big banks and financial institutions will only lend to companies that have been operational for two years or more.
Your business should have annual revenue of £50K or higher. This could be lower depending on the lender.
For a secured business line of credit, the lender will ask for inventory or accounts receivable as collateral.
The lender may ask you to present financial statements and income tax returns with your application.
The lender may also analyse your financial health by asking for proof of revenue and check your company’s economic ratios like debt to equity, working capital ratio, or debt service coverage ratio, which measures a company’s ability to repay its debt.
There are also a few other things you should consider before applying for a working capital loan:
Your business’ age
It is unlikely that you will be able to secure a finance facility if you have recently started your business. You need to wait for a few months to a year to gauge if you need more working capital than you currently have and how you would put it to use. The interest on working capital loans can be high and your business should be prepared to assume that kind of liability.
Evaluate how much you need and what financing option is best for you
If you think your business needs working capital for short-term needs, spend some time analysing how much money you need, what time period you need it for, and how much you can pay back in instalments. If you are a company supplying goods to a bigger business, you could look at financing structures like supply chain finance or invoice factoring, that can provide you with an immediate cash infusion while you wait for your invoices to be cleared with your buyers.
Evaluate your credit score and get your documents ready
A credit score of 600 or above will help you negotiate a good rate with the lender, but you could secure a loan even if your credit score is less than that. You don't need a good credit score or a credit history for merchant financing or supply chain financing options. You can consider those if your business has credit card transactions or other receivables in the form of invoices to be cleared.
For a working capital loan, your lender will ask you for documentation related to your company's other loans, tax returns, and bank statements. You should get all this in order before you apply to make the process smoother for your business.
Choose a lender and submit an application
It's important that you pick a lender (banks, online lenders, or other financial institutions) that match your needs perfectly. Look for favourable interest rates, repayment terms, and other fees before you pick one and submit your application. Not all lenders are the same, so even if you aren't able to secure a loan from one lender doesn't mean you can't from another.
The advantages of working capital finance
It’s flexible
You are free to use a working capital loan or other financing in any way you want to for your operational expenses. Lenders don't put restrictions on how the money can be used, and you don't have to explain how you spend it.
It's fast
Working capital funding can be available within 48 hours. It saves you time and a lengthy application process that is required for traditional bank loans.
It is unsecured
Not all types of working capital financing need collateral. However, you will need a good credit rating to secure financing on favourable terms.