All About Working Capital Financing

Working capital financing is an important financing tool for funding an organisation’s short-term business requirements, mainly its working capital. It also offers liquidity to the business so that it can fund its day-to-day business operations including overhead, payroll, and various other expenses. 

Components of Working Capital

Working capital is essentially the difference between an organisation’s current assets and current liabilities.

Current assets are liquid in nature and could be converted into cash in a span of a year — and the organisation’s current liabilities include payroll, accrued expenses and accounts payable.

Typically, current assets and current liabilities used to compute the working capital include the followings:

Current assets include,

• Cash and cash equivalents,
• Money in bank and customer’s undeposited cheques,
• Inventory including raw materials, finished goods and work in process,
• Marketable securities like treasury bills and money market funds,
• Short-term investments which are intended to be sold off within a year,
• Accounts receivable, after deducting allowances for bad and doubtful accounts,
• Notes receivable like short-term loans to clients or suppliers which are maturing within a year,
• Other receivables like income tax refunds, insurance claims and cash advances to employees,
• Prepaid expenses, such as advance rent, insurance premiums, etc.

Current liabilities include,

• Accounts payables,
• Notes payable that due within a year,
• Taxes payable,
• Outstanding salaries and wages,
• Interest payable on loans,
• Other accrued expenses payable,
• Loan principal payable within a year,
• Deferred revenue.

Nature of Working Capital Finance

Some of the basic attributes of working capital finance are listed below:

• Working capital finance isn’t meant for investments or buying long-term assets; they are meant to offer assistance to working capital for covering an organisation’s short-term operational requirements.

• Working capital finance is utilised for debt payments, costs payroll and rent.

• Businesses with cyclical sales or high seasonality could rely on working capital finance to help their business in periods with reduced business.

• Working capital finance is often tied to the owner’s personal credit, so defaults or missed payments can hurt the credit score.

• Working capital finance is sometimes unsecured. However, only businesses with an optimal credit rating can avail the financing unsecured. Businesses with lower ratings need to offer collateral to avail working capital finance.

Types of Working Capital Financing Products

There are several ways to avail working capital finance such as vendor financing, invoice discounting, channel financing, etc. Some of these are discussed below:

Vendor Financing – Vendor financing describes a lending arrangement by a vendor to customers utilising such funds for purchasing from such specific vendors. Vendor financing arrangements usually carry high-interest rates as compared to traditional lending institutions. 

Invoice discounting – Invoice discounting refers to a process wherein a business sells its invoice to third parties, usually known as a financing company. After selling the invoice, the business receives a percentage of the invoiced amount while the financing company assumes the responsibility of collecting the payment for the invoices from the buyer.

Channel Financing – Channel financing is an innovative working capital financing facility for financing channel partners such as dealers, buyers or distributors for the purchase of goods and services from a business. With channel financing, an organisation could leverage the opportunity not just to improve its relationship with its channel partners, but also to improve its business liquidity and relieve the stress from its cash flows. Financial institutions fund the buyers, dealers, distributors so they’re able to pay for their inventory supplies. The credit provided by the financial institutions is settled by such buyers, dealers and distributors once they make the sale of their products and in accordance with the terms of the agreement.

Bank Overdraft – Bank overdraft is a withdrawal limit that is pre-approved by the bank where the company has its current account. Besides a good credit score, a long working relationship with the bank is also a prerequisite for a bank overdraft. Interest is payable only on the amount withdrawn by the business, even if the limit sanctioned by the bank is higher. However, the interest rates are usually 1%-2% higher than the prime lending rates of banks and other financial institutions.