From a capital perspective, businesses seek financing that is appropriate to their asset conversion cycles.
The conversion of assets into cash. It is the timing of the conversion of assets which drives the financing decisions that all businesses face.
As an example, consider a company whose sales are increasing (both seasonal or long-term trend). What happens on the balance sheet? To the asset account balances?
- Cash Account
- Neutral or Declining
- Inventory Account
- Increasing; required to support sales volumes
- Accounts Receivable Account
- Increasing; more customers on credit terms
- Fixed Asset Accounts
- Stable; may increase dependent on type of business.
The rate and scale of changes to the asset accounts, naturally depend on the type of growth – short term seasonal or long term. The point is, growth needs cash to support it. The company needs to find financing that is flexible enough to support the changes to its asset accounts.
If the asset conversion cycle is long and stable, long-term financing is needed. Conversely if the asset conversion cycle is short, short-term flexible financing is needed.
The difficult question though is “how much long-term financing (stability) and how much short-term financing (flexibility) is optimal? Especially given that asset conversion cycles tend to overlap.
This brings me to the topic of Working Capital.
In my experience, Working Capital has been looked at as a short-term finance driven number: current assets less current liabilities (although there are a few issues with this calculation when considering liquidity, so don’t rely on it).
So what is it, and how should it be funded?
Traditionally, credit providers place importance of the level of Working Capital. But how much is enough? An old definition of Working Capital, and one I still think is correct would be:
Working Capital is the amount of long-term financing used to finance current assets.
Thinking this through, there will always be a portion of current assets; Inventory and Accounts Receivable, that don’t convert to cash. Even at the lowest point of a company’s business cycle, these accounts will always have balances. The company should want to match debt repayment to the rate at which current assets convert to cash.
As a ratio of these current assets are “long-term”, the company should finance this ratio of current assets with long term financing: Working Capital.
Determining Working Capital adequacy – how much is needed?
- Firstly, I need to bring in another concept here; Working Investment, which is a simple way to calculate financing caused by a cash flow timing difference.
- It is Inventory and Accounts Receivable less Accounts Payable and Accrued Expenses.
- A simple method of getting a feel for the Working Capital number is:
- To take the highest point of Inventory and Accounts Receivable assets accounts.
- Estimate potential shrinkage at high point of these accounts; deducting old inventory and bad debt
Your Working Capital requirement = low point working investment + high point shrinkage
While this is obviously not exact, it is a good guide to where a business should be.
How can Global Asset Finance Limited help?
Clearly cashflow timing differences and growth in assets create funding pressures. Global Asset Finance Limited, with its partner funders offer supply side financing applications which ameliorate these pressures.
We can support businesses by creating headroom in trade payables. Importantly our programmes are:
- On call
If you would like more information on managing your working capital requirements or would be interested in how Global Asset Finance Limited can help you further with this please contact Stephen Gruenewald or +44 (0) 7721 565802 Email: Sales@globalassetfinance.com
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