Working capital finance

Life as a small business can be unpredictable, which is why working capital finance is one of the most important types of business lending. Access to capital when it’s needed helps businesses manage cash flow, cover operational expenses and plan for growth when the chance arises.

Here we’ll explore why working capital matters, the types of working capital finance, from working capital loans to trade finance, as well as how to set your working capital policy.

What is working capital and why does it matter?

In finance, working capital is a measure of a company's short-term liquidity – i.e. cash on hand – and its ability to meet its short-term obligations. It’s calculated as the difference between a company's current assets and current liabilities. 

Understanding Working Capital

Working capital is calculated using the following formula:

Working Capital = Current Assets−Current Liabilities

In this formula, this means:

• Current assets: Assets that can be converted into cash within a year, such as cash, accounts receivable, inventory, and marketable securities.
• Current liabilities: Outgoing costs that a company needs to settle within a year, such as accounts payable, short-term loans, and other debts

Why Working Capital Matters

The amount of liquid capital you have available to work for your business is a crucial measure of your ability to adapt, invest and survive as the market around you changes. Your working capital plays a key role in:

1. Financial health: Positive working capital ensures that a company can pay its bills and invest in its operations. A negative working capital can signal potential liquidity issues, meaning you may have trouble meeting your debts. 
2. Operational efficiency: It allows businesses to maintain sufficient inventory, manage receivables, and ensure timely payments to suppliers.
3. Financial Stability: Adequate working capital provides a cushion against financial difficulties and economic changes, even during challenging times.
4. Borrowing ability: Sufficient capital reserves enhance a company's creditworthiness, making it easier to secure loans and attract investors.
5. Growth and Expansion: Liquidity enables businesses to take advantage of growth opportunities, such as expanding operations, entering new markets, or investing in new projects.

How does working capital finance work?

Working capital finance refers to any kind of funding used to cover a company’s day-to-day operational expenses. This includes paying for inventory, salaries, rent, and other short-term liabilities. It’s often short term finance, rather than a long-term loan or investment for a major project. 

Working capital finance is not always a sign your business is in trouble. The ability to obtain extra capital when it's needed ensures that you have sufficient liquidity to achieve your goals without overstretching your cash limits. However, if you find yourself consistently turning to finance to keep your business on track, it may be a sign that you have underlying issues that need addressing.

What are the main types of working capital finance?

There are several methods to finance working capital, each with its unique advantages and suitable applications. The right choice for you will depend on your business and the challenges or opportunities you’re facing. 

Short-Term Working Capital Finance:

Short term working capital finance prioritises speed and flexibility, providing quick capital that you can use for a variety of purposes.

• Short term loans: A working capital loan, such as iwoca’s Flexi-Loan can provide access to financing in as little as 24 hours, with a flexible credit limit. Businesses can draw down funds as needed and only pay interest on the amount they actually use.
• Bank Overdrafts: Business overdrafts enable companies to withdraw more money than they have in their account up to a certain limit. Ideal for managing short-term cash flow needs.
• Invoice Financing: With invoice finance you can borrow against their accounts receivable. This provides immediate cash flow based on outstanding invoices, which can then be recouped by the lender later.

Structured Working Capital Finance:

Some kinds of working capital are tied to certain business areas or assets, enabling companies to invest in inventory or equipment.

• Asset-Based Lending: Asset-based loans are secured by company assets such as inventory or accounts receivable. This method provides higher loan amounts based on the value of assets.
• Supply chain finance: Supply chain finance helps cash flow by allowing businesses to extend payment terms to their suppliers while receiving early payments themselves.
• Trade credit: Trade credit allows businesses to purchase goods or services on credit and pay for them later. This helps maintain cash flow without immediate outlays.

Setting your working capital financing policy

As with every element of running a business, there is a variety of ways to approach working capital financing – some businesses rely heavily on credit and financing to aim higher and achieve more, while others try to reduce risk as much as possible to not build up debt. 

Conservative Approach to Financing Working Capital

A conservative working capital financing policy focuses on minimising risk by maintaining a higher level of current assets relative to current liabilities. This strategy involves using long-term financing to cover permanent current assets and some temporary current assets.

Benefits:

• Reduced risk: Higher liquidity ensures that the business can meet its short-term obligations even during unexpected downturns.
• Financial stability: Provides a buffer against financial issues, making it easier to manage cash flow.

Drawbacks:

• Lower returns: Excess cash in your business may lead to lower returns on assets since the funds are not being used for potentially profitable investments.
• Higher costs: Long-term financing often comes with lower interest rates, but the overall costs may be higher due to longer repayment periods

Aggressive Approach to Financing Working Capital

An aggressive working capital financing policy seeks higher returns by minimising the level of current assets and using more short-term financing – ie hold less, borrow more.

Benefits:

• Higher returns: By investing excess cash in profitable ventures, businesses can achieve higher returns.
• Cost flexibility: In some cases, short-term financing can be less expensive in terms of total interest paid over the term, but this depends heavily on the specific financing options and market conditions.

Drawbacks:

• Increased risk: Lower liquidity increases the risk of cash flow shortages, which can lead to financial issues.
• Uncertainty: Relying heavily on short-term financing can create uncertainty, especially if interest rates rise or the business faces unexpected expenses.

Choosing the Right Approach

• Business type: Stable, mature businesses may prefer a conservative approach, while fast-growing startups might opt for an aggressive policy.
• Market conditions: In volatile markets, a conservative approach can provide stability, while in stable markets, an aggressive approach might yield better returns.
• Risk tolerance: Management’s willingness to take risks plays a significant role. A conservative approach suits risk-averse managers, while risk-tolerant managers might prefer an aggressive strategy.

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Advantages and Disadvantages of Working Capital Finance

Like any financial tool, working capital finance comes with its own set of benefits and drawbacks. 

Advantages

• Improved cash flow: By securing funds to cover daily operational expenses, businesses can avoid cash flow gaps that may disrupt their operations.

• More flexibility: Working capital finance options, such as overdrafts and revolving credit facilities, offer flexibility to meet short-term financial needs without long-term commitments. 
• Agile growth: External cash on hand helps you move faster when opportunities arise, such as hiring new staff, launching products, or entering additional markets, without depleting cash reserves.

Disadvantages

• Cost: Working capital finance can come with high costs, including interest rates and fees, which can build up over time and hit your profitability.
• Higher debt: Relying on working capital finance increases the debt your business is holding – failure to keep up can lead to financial distress or damage the business’s credit rating.
• Risk of Over-Reliance: As mentioned above, businesses that consistently rely on working capital finance may become dependent on external funding, which can be risky if financing terms change or become less favourable. 

How to raise working capital finance with iwoca

When you need working capital finance, iwoca’s Flexi-Loan can provide the cash you need quickly and flexibly. 

• Speedy application: Getting a working capital loan with us is straightforward, quick and simple. We’ve designed the process to be fast and flexible for your small business.
• Tailored decisions: We’ll take up to 24 hours to verify your details and give you a decision based on your eligibility. You can choose whether to go ahead after we’ve sent you an offer.
• Use your working capital finance: If you accept our offer, we’ll transfer the funds to your account and you can start spending the money. 

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