Most businesses face cash shortages from time to time. They produce goods and provide services which customers pay for later. Any hiccups in the payment cycle can create real problems for even the best-run companies, which still have to pay salaries, utility bills, suppliers and so on.
We look at the working capital funding options available to help companies get through those difficult periods.
What is working capital?
Working capital is a fundamental concept in business that, in simple terms, relates to cash tied up in the everyday running of a company, says Derek Murphy, managing director, financial advisory, at Deloitte.
“In an era where both high inflation and interest rates are an ongoing challenge, businesses would be well advised to take a proactive approach to managing working capital as a mechanism to maximise cash flows sustainably.
“Working capital is the lifeblood of a business and, when effectively managed, enables organisations to meet financial obligations on time, avoid liquidity issues and provide a platform to take advantage of growth opportunities without relying heavily on external financing.”
Speciality asset-based lenders and other alternative working capital providers and platforms play an increasingly important role in supporting Irish SMEs and other corporates with working capital financing solutions, says Murphy.
“These providers have lending products which can be tailored to a borrower’s specific needs and can be more flexible than those traditionally available from banks,” he adds. “These include inventory financing, the financing of receivables from international jurisdictions, supplier financing and purchase order financing.
“For larger corporates and publicly listed companies, non-recourse trade receivables financing and securitisation programmes are also innovative approaches used to fund working capital funding needs.”
Understanding where exactly a business’s working capital funding is tied up is crucial when determining which form of working capital financing is most appropriate, says Murphy.
“For example, stock financing is more appropriate than invoice discounting as a form of working capital financing if a company has fast-paying customers but significant levels of inventory on the balance sheet.
“In other industries, where seasonality can be a significant factor – for example, food processing or the agribusiness industry – it can be very important for a business to have a combination of several forms of working capital funding in its financing package.”
Payment cycle concerns
Several factors can disrupt the payment cycle, including delayed customer payments, inaccurate invoices, economic downturns, supply chain disruptions and poor internal cash flow management, says Stephen McCarthy, head of business development, Bibby Financial Services.
“To address these issues, businesses can implement a range of solutions to help mitigate these disruptions, including clear payment terms, offering early payment discounts to clients and using automated invoicing and reminders to minimise delays,” says McCarthy.
“Ensuring invoice accuracy, having a robust customer validation system in place – ie proof of delivery – and promptly addressing discrepancies can also help.”
Diversifying the customer base and maintaining a cash reserve can lessen the impact of economic downturns for businesses of all sizes also, as well as building strong relationships with multiple suppliers and having contingency plans to help reduce supply chain risks. Additionally, regular cash flow monitoring and using working capital financing options can help manage internal cash flow effectively, McCarthy says.
Ways to fund working capital
The traditional overdraft is probably the most flexible working capital solution, generally uncommitted in nature, meaning there is typically no charge unless it is utilised, says Paul Rickard, director in corporate finance at Forvis Mazars.
“As such, they are very useful facilities to fund working capital requirements whilst also acting as a standby facility to cover unexpected payments or any delays in payment receipts.
For companies with substantial “core” working capital needs, committed revolving credit lines provide certainty of funding essential for day-to-day operations, Rickard says.
“These facilities charge interest on drawn amounts and a commitment fee on undrawn amounts, offering stability in exchange for this additional cost,” he adds. “Asset-backed facilities have grown in popularity in Ireland, allowing businesses to leverage working capital assets (like inventory and receivables) to improve liquidity.
“The most common type of asset-backed lending in the Irish market would be invoice discounting (providing debtors are suitable). However, some companies also use stock financing or a combination of both, depending on their asset profile.
To manage payment cycle hiccups and avoid cash flow shortages, businesses can use strategies such as invoice financing to access funds tied up in unpaid invoices and implement clear payment terms with customers and clients to encourage on-time payments, says McCarthy.
“Recent Bibby Financial Services research reveals that 68 per cent of SMEs say it is taking significantly longer for customers to pay invoices in full,” he says. “Maintaining a solid cash reserve, automating payment reminders to clients and offering diverse payment methods can help streamline payments and reduce delays.”
Additionally, negotiating flexible terms with suppliers and closely monitoring cash flow will allow businesses to anticipate shortfalls and take proactive steps to maintain liquidity, McCarthy adds.
“These measures ensure steady cash flow despite any disruptions in customer payments,” he says. “Businesses of all sizes can experience hiccups to the payment cycle – from SMEs to large multinational businesses, so it’s important for all to be vigilant.”
Attitude shift
The past decade of unprecedented growth, coupled with the availability of cheap financing, has created a sense of comfort with working capital management. However, we are now seeing a considerable shift in how companies are prioritising working capital as a mechanism to insulate themselves from the risks of economic uncertainty, says Murphy.
“Working capital presents an attainable value creation opportunity, not only in business as usual but also in an M&A environment, as sellers are rightly placing more emphasis on cash and working capital as a mechanism to maximise deal value.
“Effective working capital management is essential for maintaining operational efficiency and financial health. By understanding the available funding options, addressing payment cycle challenges proactively, and implementing sound financial practices, businesses can navigate the complexities of cash flow and position themselves for success.
“That is why working capital deserves the same level of executive focus and rigour as sales and profit.”