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What is Working Capital Financing?

What is Working Capital Financing?

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What is Working Capital Financing?

What is Invoice Factoring?

For businesses strapped for cash, one possible remedy involves converting accounts receivable and outstanding invoices into cash through the use of a receivable factoring company.

Related: What is invoice factoring?

An Overview of Working Capital

In its most basic form, working capital simply involves taking your business’s current assets and subtracting its current liabilities. 

Current assets include resources such as the cash in your business bank accounts, inventory, accounts receivable, and other short-term assets your business needs to operate on a day-to-day basis.

Current liabilities include accounts payable, wages payable, other types of short-term accruals, and short-term debt.

The calculation, in summary, looks something like this:

Net Working Capital = Cash + Inventory + Accounts Receivable – Accounts Payable – Wages Payable – Other Short-Term Liabilities and Accruals

In other words, businesses that have a high degree of accounts receivable and minimal current liabilities have positive working capital. Negative working capital entails the exact opposite with current liabilities constituting a greater share of the equation compared to current assets.

Related: What is working capital

Positive vs. Negative Working Capital

Positive working capital indicates that a business has more accounts receivable and cash on-hand than it has current liabilities such as accounts payable. On a cash flow statement, this positive working capital presents as an outflow of cash since, in the case of receivables, that cash remains tied up in receivables.

Negative working capital, on the other hand, implies the opposite. Negative net working means that a business has received credit from suppliers through accounts payable, employees through wages payable, or banks through notes payable. Negative working capital therefore shows up on the cash flow statement as an inflow of cash. 

Working Capital and Invoice Factoring

In business, cash functions as the most useful current asset. Without it, a business cannot make payroll, pay rent, or manage its daily operations. Unpaid invoices mean that a business does not have the cash it needs. Instead, a business essentially extends credit to its customers when it has outstanding accounts receivable.

For businesses with unpaid invoices and aged receivables, cash may become limited. In order to access that cash, one type of business financing that is available is invoice factoring. 

Invoice factoring involves selling your accounts receivable to “factoring” companies. In exchange for your accounts receivable, a factoring company will pay a lump sum of cash. 

However, this sum of cash does not come for free. Factoring firms will typically charge their clients a percentage of the overall receivables balance as a fee and only pay a portion of the total amount prior to collecting that fee. 

While there exists some downside with this approach, invoice factoring can even out the working capital problem that many small businesses face. Ultimately, the goal involves improving access to much-needed cash in order to pay critical suppliers and keep the lights on.

How Working Capital Affects Cash Flow

Consider the following example in order to better understand how working capital management can affect the all-important free cash flow a business needs to survive.

Imagine that you run a small lemonade stand business. Your principal costs include ingredients to make lemonade, the cost to rent a small space in your local city, and an employee to man the register.

Each day, your lemonade stand generates sales of lemonade, suppliers must receive their payments, and your landlord needs payment every month. 

Imagine that you begin extending credit to your customers in order to generate more demand. In other words, you extend a 45-day interest-free credit period to each customer. 

However, you must also pay your suppliers and make the rent each month, otherwise, they won’t send you more ingredients to continue making lemonade, which will eventually close the business. 

In this scenario, your business would not have sufficient cash to make these payments. Instead, that cash exists as receivables and not an actual sum of cash that you can use to pay your bills,

An invoice factoring company can convert those 45 day receivables into immediate cash with which you can pay your bills in exchange for a fee. 

Invoice Factoring Companies

There exist a variety of invoice factoring companies, some of which operate exclusively over the web. You should only consider working with companies that have a trusted reputation and that you can independently verify will work with your business on an affordable basis.

Other Types of Working Capital Financing

In addition to factoring services, businesses have several other working capital financing options from which to choose, including:

  • Traditional Bank Loans: Lenders can extend an SBA loan or a conventional business loan to businesses with strong finances and a principal guarantee. A bank loan will require collateral, unlike invoice factoring.
  • Asset Financing: Asset financing is a type of financing that allows business owners to use their assets as collateral for a loan, but don’t qualify for a traditional bank loan.
  • Business Credit Cards: In many cases, a specialized business credit card can act as a stop-gap for working capital unevenness. 
  • Merchant Cash Advance: In exchange for the future sales of a business, a merchant cash advance provider will extend a lump sum of money. These cash advances or MCAs differ from factoring services in that they do not represent a purchase of receivables. 
  • Business Line of Credit: Another option involves making use of a business line of credit from a traditional lender. 

What’s the Best Choice for Your Business?

An invoice factoring service may provide the best option for your business if you need immediate cash flow based on your accounts receivable. This service enables your business to convert receivables on the balance sheet into cash in exchange for a factoring fee. 

For a small business owner who needs immediate liquidity in order to pay third-party expenses, this service could act as an invaluable resource to keep the lights on. However, the various fees and lost potential recognized revenue deserve careful attention to balance short-term cash needs with long-term growth, particularly for startups.

What is Working Capital Financing?

What is Working Capital Financing?

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