With COVID-19-driven economic disruptions over the past 18 months many SMEs have been given a sharp reminder just how important sufficient levels of working capital and cash flow are to their businesses.
If you’re wondering what working capital is, by definition, it refers to the difference between the current assets and current liabilities (which are short-term liabilities) on a business’ balance sheet. Current assets are basically anything that a business can turn into cash within the next 12 months and current liabilities are the costs and expenses a business incurs within that same period.
Working capital is a good reflection of a business’ short-term financial health. It can help determine whether a business has enough short-term assets to cover their short-term debt and maintain their day-to-day operations.
Different business types will have higher working capital requirements than others, including businesses with physical inventory, like manufacturers, retailers and wholesalers. Seasonal businesses or those experiencing decent growth should also have a substantial increase in their working capital requirements.
How to assess your own Working Capital requirements
Most businesses obviously want a positive working capital ratio - this ratio is measured as current assets divided by your current liabilities. However, most analysts believe a good working capital ratio is anywhere between 1.2x and 2.0x, that is, having $2 in current assets for every $1 in current liabilities. If your business falls below this minimum threshold, you have a liquidity issue and it could mean you need additional capital in the business.
How to increase your Working Capital
There are a number of ways you can improve your working capital. Making sure you understand your cash conversion cycle is certainly a good start. This cycle represents the time between money going out the door for your inventory and money coming back in from your sales, and obviously the quicker a business can turn this around the better. Without going into too much detail, there are three main elements:
- A business needs to decrease the average number of days it takes to sell its inventory which accelerates the time it takes to receive cash in return that can be reinvested again.
- A business needs to decrease the average number of days it takes to collect its outstanding invoices/accounts receivables which allows a business to reuse that cash sooner.
- A business needs to increase the average number of days it takes to pay its suppliers/accounts payable which allows the business to hold on to cash longer, which allows it to be used effectively in the business within this timeframe.
The stages above involve effective negotiation of credit terms with your customers and suppliers as it can be extremely difficult managing your cash flow when working with large customers with long payment terms or slow-paying customers. You could also look at offering incentives for early payments, such as a discount off the invoice amount.
Where to go for Working Capital
According to a recent Xero Small Business Insights report, more than 60% of SMEs are looking to borrow and most are looking for working capital support. The report says the main reason for this was due to delayed credit collection terms, particularly from large private sector companies. It also found that the average debtor period is more than 50 days and rising. The report also noted that nearly half of all SMEs experience negative cash flow at different periods throughout the year with most of this felt in the months leading up to Christmas and into January.
As all SMEs have a transactional bank account, a lot of them will look at their bank’s options first. This could be in the form of an overdraft, a line-of-credit, trade finance or an invoice finance facility. However, while banks can be the most effective in terms of price, the major banks can be reluctant to provide additional facilities in the current climate and especially without additional security in the form of charges over the business or a director’s property.
An alternative could be a specialist trade finance or invoice finance provider. Generally, trade finance requires security over the business or director’s property and invoice finance requires security over all outstanding invoices. These facilities will be more expensive than the major banks, but still provide a good solution.
Businesses need to look at all their options and work out the best fit for their requirements and sometimes they will need to use different facilities in tandem to get the best results. Whichever of these services is most appropriate may depend on where the cash flow holdup is. Understanding your unique finance needs may be a bit tricky at the start, but once you do, it can go a long way to ensuring your business runs smoothly.
If a business is struggling to get an increase or a facility with their bank or a facility from a specialist working capital financier, a number of businesses are turning to non-bank lenders to overcome cash flow shortages with an unsecured facility. The major advantage of an unsecured facility is that it can sit beside other finance facilities (including the bank or working capital financier) and not cause any issues at all as it is completely unsecured and works really well as a backup facility which can also be effective for seasonal or growing businesses.
While some of these unsecured facilities can be more expensive, there are still some financiers with very reasonable rates, so once a business has either been declined an increase or tapped out its secured facility limit, the best way to make sure 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.