Overview
It’s a known fact that most start-ups usually run on tighter budgets while struggling with the pressure of performing better or giving better output on lesser funds when already dozens of competitors are existent in the market. Therefore, one key strategy that could be helpful for start-ups, in the long run, is better working capital management. Working capital management is a business strategy designed to ensure efficient management of working capital through monitoring the application of current assets and current liabilities to fulfill the short-term operating costs and short-term debt obligations of a start-up. All businesses need working capital, but the requirement of working capital may vary depending on the business.
Now, what does working capital mean anyway? Working capital or Net Working Capital is the difference between the current assets and liabilities of a company and represents the liquidity, operational efficiency, and short-term financial health of any business, organization, or any other entity including governmental entities. Working capital also indicates the funds required to carry out day-to-day business operations, such as rent payments, salaries & wages, payments made to vendors, and other necessary expenses for a business. Accordingly, if a company has a positive working capital, it means that the company has enough funds and potential to invest and grow.
However, in cases where the current assets are not enough to cover the current liabilities, the company might have trouble paying back to its creditors or even go bankrupt. Similarly, it is not beneficial to maintain a high net working capital, as it would mean that either the start-up has excess inventory or is not making efficient use of resources wisely.
Therefore, every business needs to balance its working capital through working capital management. It is to be noted that adopting working capital management could help a business to improve its cash flow management and effective use of resources in the long run, which will in turn reduce the dependency of business on external sources for meeting its capital requirements. Now with the concept of working capital is clear, one needs to know about different types of working capital and the various sources from which it can be derived for the start-up business.
Sources of Working Capital
Primarily, there are two categories of sources of working capital.
I. Short-term Financing Sources
i. Overdraft Facilities
An overdraft facility is a credit arrangement entered by a bank/FI with a business organization or start-up that allows the account holder to either use or withdraw amounts higher than they have in their bank accounts up to the approved limit in pursuance of the overdraft agreement. But, the bank/Financial Institution may seek any collateral and charge interest on the use/withdrawal of the amount.
ii. Bill Discounting/Accounts Receivable Financing
Nowadays, various Banks/ Non-banking financing institutions (NBFCs) offer invoice discounting facilities to start-ups and other businesses. It is a type of financing facility under which a business is granted working capital for a portion of its accounts receivable which are assets for an organization. These agreements could either be structured based on the sale of assets or as a loan. After which, such bank/FI undertakes the collection of amounts from the customers/third parties.
iii. Customer Advances
One effortless way to meet the working capital requirements of a business is seeking some advance payments from customers in advance which affirms the order placed and allows the availability of some capital to the business. No interest is to be paid by the business to the customers for such advances. Thus, it is one of the cheapest sources of raising funds for a start-up to meet its short-term working capital requirements. Further, many financial institutions insist businesses receive some payments in advance from customers before selling goods or providing services, especially in the case of large orders.
iv. Acceptance of short term deposits
Many start-ups and other businesses find it convenient to meet their working capital requirements by inviting short-term deposits (from six months to one year) from their employees, shareholders, and the general public to deposit their savings with the company under the provisions of the Companies Act 2013 at rates higher than the prevailing rates offered by banks or financial institutions.
v. Loans from Commercial Banks
Small & Medium scale businesses may apply and obtain short-term loans from commercial banks at concessional rates either with or without collateral security to meet their working capital necessities. Apart from the creation of a mortgage on the assets of the company, there is no other formality required in the process. Further, the repayment of the loan could be made either in installments or as lump-sum payments.
II. Long-term Financing Sources
However, when a start-up requires funds for more than one year, it becomes logical to look for long-term sources of working capital. Some of the sources have been described below-
i. Long-term Loans-Also known as working capital loans, these Long-term Loans may be either temporary or long-term for a term of either seven years or more. The funds so obtained are not used to purchase assets or make investments, instead are used to meet the shortage in working capital for the management of daily business operations.
ii. Retained Profits-At times, businesses prefer to retain a portion of profits to fulfill their working capital needs rather than making business investments or making dividend payments to their shareholders. Retaining profits is one of the best ways for a start-up or any other business to become self-sufficient and reduce dependency on external sources for funds.
iii. Share Capital- A start-up may raise funds for working capital or any other needs by offering a stake in their business to any prospective investors or stakeholders in the business. Such stakeholders may be either banks or financial institutions, other business entities, or investors. But, the response from such potential investors depends upon several factors such as business reputation, growth prospects, perceived profit potential, and general economic condition.
iv. Debentures- Debentures are the debt instruments that are issued by a start-up to the general public, financial institutions, and investors to obtain funds in form of loans along with a fixed rate of interest for a certain period which is generally of longer duration.
Factors that Affect Working Capital
The process of managing working capital is a never-ending process for accounting or finance professionals of a business to manage the day-to-day business operations of a company and keep the business going without any glitches. There are two categories of factors that may affect working capital- Internal & External Factors.
1. Internal Factors which affect working capital
i. Structure of the Organization–
Firstly, the structure of business operation determines the usage of working capital in a business. For instance, some businesses operate in a relatively complex administrative procedure, making their marketing, production, and distribution centers at locations that are far from one another, which leads to wastage of capital resources and an increase in prices spent on others. However, businesses having a smaller group of staff and their hubs of production, distribution, and storage are situated near each other could save a lot of funds by avoiding unnecessary expenses.
ii. Manner of using working Capital– How do companies invest the capital they have borrowed? Where are most of the resources being diverted? The working capital of a start-up business gets affected by the borrowing and the frequency of borrowing and investment by an organization. For instance, a business may invest funds for purposes such as the improvement of storage facilities, training/development purposes, entering new markets, offering diversified products, adding new capabilities, etc. It is often suggested that businesses should avoid borrowing capital, but the level of working capital also depends on the final use of these investments.
iii. Size/Growth Rates of Start-up– Generally, when a business is on a fast track of growth, there is a higher requirement of working capital for meeting various needs such as higher production and hence more requirement for raw materials, improvement in marketing & distribution channels in new locations, etc. This whole process needs a whole lot of funds, which could pump in working capital to manage the increasing business needs.
iv. Complex working capital management strategies-While accounting teams for each start-up are more proactive and efficient than the others to manage cash-in-hand. A proficient accounting team has an effective working capital strategy which could be complex at times. For example, some accounting teams may not allow long-term credit to their debtors, have variable terms & conditions from their creditors and banks, may implement prices effectively, and maintain a shorter working capital cycle, etc.
2. External Factors which affect working capital
i. Interest Rates– The working capital of a company may be affected by the prevailing rates of interest charged being charged by banks & financial institutions on loans and overdraft facilities. In the early stages of the business or case of insufficient assets for collateral purposes, businesses might hesitate to borrow or the sources of repayment of loans or EMIs. Whereas it is comparatively easier for businesses to borrow funds in case of low-interest rates and liquidity is affordable and accessible.
ii. The Economy–Several factors such as the condition of the domestic/global economy, marketing conditions, business, political, and environmental risks, etc. may affect the position of working capital of a start-up. The more the diverse international operations of a business more will be risks of the breakdown of the company’s supply chain management. Therefore, a start-up business must always have future strategies and plans in place to ensure that the working capital is never an issue for the business.
iii. Banking Services–Inability to secure capital from the banks or financial institutions could adversely affect the liquidity of the business. There could be many reasons for the failure of a start-up to obtain a loan such as inadequate documentation, previous defaults, insufficient collateral, etc. On the other hand, businesses that can raise capital through banks/Financial institutions or equity or debt financing will have higher liquidity available for their business.
iv. Technological innovations–Today’s top global start-ups, including those businesses that are technologically oriented and have better systems in place to accurately project their demands, purchase raw materials on time, and effectively manage their distribution channels. Further, the use of online invoicing/payments could significantly lower expenses ultimately optimizing their working capital.
v. Threats from Competitors –Each start-up is prone to numerous competitors in the relevant market. Most of the time, a business may have to agree on terms or do things to compete with its competitors in the market, which in turn may increase pressure on the business. For instance, a company may have to declare and pay a dividend which might make it difficult to negotiate with its vendors. This, in turn, will loss of control of the business cash flow and adversely affect the working capital.
Importance of Working Capital
An effective policy for working capital management and its dedicated implementation could ensure financial health and operational success as a business. The ability to utilize working capital management is a hallmark for maintaining a balance between growth, profitability, and liquidity within a business organization.
Provided below are the reasons that emphasize the importance of working capital for a start-up business-
- Managing Liquidity of a Business– By analyzing the day-to-day expenses or costs to be incurred in near future, the accounting & financial team can manage the liquidity of their business accordingly.
- Avoiding Out of Cash Situations– Failure to properly manage the day-to-day expenses of a business may result in liquidity issues within an organization. Thus, planned management of working capital can help to avoid such circumstances and manage cash effectively.
- Role in Decision Making– By appropriately studying & planning the fund requirements for regular business needs, the finance team can undertake proper management of funds and can decide on available funds and the required funds.
- Enhances Business Value-Proper management of funds causes the responsible managers to perform their business functions effectively such as the timely purchase of raw material or payment to vendors, etc helps to enhance the value or goodwill of the business in the market.
- Helps to avoid Cash Crunches –By effectively managing the liquidity resources of an enterprise, the organization can avoid crises or cash crunches and keep the business running by paying for its daily expenses on a timely basis.
- Planning & Making investments-While having adequate resources to manage their day-to-day business, they may reserve a portion of funds for making business investments and may maximize their returns.
- Gaining Short Term Profits- Sometimes, businesses keep a large amount of sum stacked for working capital requirements that are far above their actual working capital needs. Therefore, by examining and analyzing the requisite amounts to manage the business for the short term, the start-up may invest such extra funds elsewhere for a short duration and create short-term profits for the enterprise.
- Strengthening the Work Culture of Entity-Timely payment of all expenses including payment of wages & salaries opens ways for a cooperative environment and encourages the employees and workers to work even harder.
- Improvement in Creditworthiness of the business-When the accounting & finance team of an organization understands their business requirements, fulfills all commitments timely such as vendor & creditors payments, etc. it improves the credibility of the start-up business, helping them to obtain funds from external sources as and when they are required. Further, everyone wishes to deal with parties having a reputation for honesty and trust rather than cases of fraud and mismanagement.
- Facilitates a Business to act as Guarantor-When an enterprise has established its goodwill for efficient management of resources and fulfilling payment-related commitments, it could act as a guarantor to help other businesses to get finances or contracts done easily.
Conclusion
Working capital is one of the critical business resources which needs to be balanced and managed effectively. While a negative working capital may suggest a risky situation, higher working capital may indicate inefficient management of funds tied up unnecessarily. Thus, every start-up needs to understand the concept and all the factors that may affect the availability of working capital within the organization and prepare their plans accordingly. At the same time, a start-up may also work diligently to become more self-sufficient regarding fund requirements, which would ultimately avoid wastage of energy and time in dealing with external parties such as banks or financial institutions, or potential investors, instead of focusing on reducing the costs of distribution, production, and marketing, which will leave more capital with a business to manage its business operations efficiently. This is one of the imperative goals of any start-up organization to make them more efficient and thus more profitable.
Therefore, it could be concluded that the working capital plays a vital role in achieving the organizational goals and enhancing the profitability of the business. It may be calculated, examined, and assessed either on a monthly, quarterly, or yearly basis. However, it is advised to examine and assess at least quarterly so that the results could be taken into account and timely action could be taken to improve the situation if required. Additionally, the extra funds could be diverted for any other purpose to maximize profits.
