Whether you’re new to the world of business finance, or you’re looking for better funding solutions for your business, you’ve probably come across lenders offering working capital finance. In order to decide if this category of finance is right for your enterprise, it’s essential that you understand what it means.
In this article:
- What is working capital?
- What is working capital finance?
- What types of finance are sources of working capital?
What is working capital?
First, it’s important to understand what working capital is.
Working capital, like many other finance-related terms, has a specific formula, and it’s designed to be a good illustration of a business’ liquidity (in a similar way to cash flow). That is to say, the liquidity that it has available to meet expenses or use immediately on growth projects.
In short, working capital is determined by subtracting current liabilities from current assets. If the result is positive, then this is the operating capital available to the business. If the result is negative - liabilities exceed assets - then this is known as a working capital deficit.
- Cash equivalents (such as securities and bonds)
- Accounts receivable
- Prepaid liabilities (such as prepaid taxes)
Liabilities are any obligations that need to be made within the financial year and will be settled with cash or other current assets.
What is working capital finance?
Quite simply, working capital finance is any type of financial product that is designed to boost a company’s working capital. In most cases, this type of finance will be taken out in order to meet the difficulties of day-to-day expenses, and is not a long term strategy.
However, working capital finance is sometimes used to meet a particular goal - usually related to growth. A business that wants to expand with a new office, new website, or new product line will need money that can be used immediately, and so they may look to a funding option to ensure they have the liquid cash that they need. In either case, the finance is about the short- or medium term.
What types of finance are sources of working capital?
It’s important to be aware that the term working capital finance doesn’t refer to a specific type of finance agreement. Indeed, there are many different funding options that could be classed as working capital finance if they’re designed to be used as a short-term solution. These sources of funding commonly include the following:
Short term loans are the most common type of finance that gets referred to as working capital finance, as they’re quick and often designed to be settled within the current accounting period.
Overdrafts are one of the most popular facilities for businesses that need the ability to very quickly improve liquidity, though fees can be high if repayments are not made swiftly.
3. Revolving credit facilities
These are similar to overdrafts, but aren’t tied to a particular bank account.
4. Invoice Finance
Accounts receivable are classed as assets on your balance sheet, but invoice finance is a funding option that turns them rapidly into usable cash, which is why it’s often seen as a benefit for working capital.