What is working capital?November 25, 2015 By BlueVine
Working capital is the amount of cash invested in or tied up by accounts receivables, inventory and accounts payable, thing which is need for a company to run its day-to-day operations. Put differently, it is the funds it needs or is currently tied up to meet payroll, secure inventory, purchase supplies or pay vendors while it is itself waiting to get paid on work it has performed or is in the process of performing.
All businesses need working capital. Sometimes, however, they are unable to access the cash they need because they have long payment cycles. Waiting 30, 60 or even 90 days to get paid for an invoice can put significant strain on a company’s working capital and is the most common source of cash flow issues, even for healthy companies.
Here are 8 ways to fill a working capital need:
Business Line of Credit
There are short- and long-term solutions for securing working capital financing. In the long-run, however, a business line of credit is the most flexible source of working capital. It allows you to tap into a source of working capital for as little or long as you need, and as much or little as you need up to your credit line. For working capital purposes, a term loan may not make sense since your working capital needs will fluctuate over time and you don’t wan to pay for financing you’re not using.
Accounts Receivable Financing
Accounts receivable financing (also known as “invoice factoring”) is another readily available form of working capital, and especially valuable for short-term working capital needs. (Learn more with this guide to invoice financing.)
Installment credit and vendor financing
Installment credit or vendor financing is a form of financing used to pay for goods or services over a defined time period via regular payments, or “installments”. It is essentially a loan from the vendor to the company buying the product or service.
Purchase order financing, or PO financing, is a form of financing whereby you can get cash to pay for the supplies or inventory required to fulfill a purchase order. This is more commonly used by companies with a high cost of goods sold if they don’t have ready access to an alternative form or working capital.
Income received in advance
Depending on your relationship with your customers, you may be able to request an upfront payment for products or services yet to be delivered. The income you would receive from them in advance would be an accounting liability to you because you have not yet performed the work or the delivered the product.
Some companies will use a bank overdraft as a source of working capital. This is a viable solutions when the overdraft amount is relatively small. However, banks limit how much you can overdraft by and may charge hefty fees, so it is not a reliable source of working capital for bigger cash outlays — and can be a very expensive fix.
Trade finance is a common solution used within the import/export business. To reduce risk, exporters require importers to prepay for goods shipped. Similarly, importers want to reduce the risk that the goods have actually not been shipped. To do this, the importer’s bank provides a letter of credit to the exporter, providing for payment upon receipt of documents, such as a bill of lading. In this example, the exporter’s bank may make a loan on the basis of the contract.
Letter of credit
A letter of credit is a document that a bank or other financial institution issues to a seller stating that they will pay the seller for goods/services delivered to a third-party buyer. The issuer of the letter of credit then seeks reimbursement from the buyer or from the buyer’s bank. The document is a guarantee to the seller that it will be paid regardless of whether the buyer ultimately fails to pay. This means that risk that the buyer will fail to pay is transferred from the seller to the bank or institution that issued the letter of credit.
As a business, you have many sources of working capital available to you. You’ll want to familiarize yourself with all the sources, understanding the pros and cons to know which is the best fit for your specific needs.