Working Capital Is Paramount To A Businesses Livelihood
All of the planning in the world is an exercise in futility
without the working capital to successfully carry out the plan.
If a business sells to customers on terms, then working capital
availability is dependent on cash flow timing. In most instances
a business will incur a cash flow gap between the time cash is
required for inventory, payroll and operating expenses, and the
time cash is received from customers paying on terms. Let's
explore a simple example of this timing difference that makes up
the cash flow gap:
Day 1: Your business orders materials from suppliers on N/30
terms; Day 3: Your business receives materials and begins
production (which takes 5 days); Day 8: Your business ships
product to customers on N/30 terms; Day 14: Mid month Payroll is
due; Day 30: Month-end Payroll and supplier invoice are due; Day
48: Your customer remits payment to you.
In this scenario the cash gap is 34 days, which is from day 14
when payroll is due, to day 48 when customer remits payment. The
cash gap encompasses two pay periods and a payment to your
supplier, whereas the gap normally includes multiple payments to
suppliers for ongoing customer orders. If your business is
mature and growing conservatively, or less than 10% per year,
then you probably have sufficient cash reserves or a bank line
of credit to cover the cash gap. But, if you are a growing
business with opportunity, how do you cover the cash gap?
Oftentimes a bank line of credit is not sufficient to cover the
cash gap for growing businesses because bankers look
historically to your company's past to determine how much debt
they will lend to your business in the future. Many growing
businesses have found themselves caught short on working capital
as their cash flow stretched during a period of growth.
Cash flow funding through account receivable factoring may be
just the tool needed during periods of rapid growth. Factoring
is not a loan or debt, but the selling of frozen assets
(invoices) at a discount to obtain the cash in a more timely
fashion (typically within 24 hours of invoicing your customer).
Your business sends invoices to your customers and a copy of the
invoice to the factoring company. The factoring company
purchases the invoice from your company advancing 80% of the
face amount of the invoice. When your customers pay the invoice,
the factoring company remits to you the 20% reserved, less their
fee (normally 1-5%).
In the cash gap scenario discussed above, working capital would
be enhanced by providing your company with cash (80% of the
invoice amount) on day 9! Your company would have cash flow to
make payroll on day 14, and pay suppliers and make payroll on
day 30. When your customer pays on day 48, the factoring company
remits to you the 20% held less their fee.
When planning for growth in your business it is important that
you assess the working capital needs and cash flow gap in order
to ensure that your plans can be met. Utilizing an accounts
receivable factoring program can assist in your successful
growth. But, be sure to assess the cost of the accounts
receivable program as a percentage of sales. And, make sure that
you do not have a term contract with the factoring company so
that you may exit the program whenever your business has grown
to the next plateau.