In order to fund its working capital requirement, a business needs to decide on its attitude to risk and reward and establish its working capital financing strategy.
The amount of operating working capital needed by a business depends primarily on its level of sales revenue.
For example, if a business has monthly sales of 10,256, cost of sales of 45%, accounts receivable days of 45, inventory days of 60, and accounts payable days of 30, then the operating working capital is calculated as follows.
Accounts receivable = 45 x 10,256 / 30 = 15,385 Inventory = 60 x 10,256 x 45% / 30 = 9,231 Accounts payable = 30 x 10,256 x 45% / 30 = 4,616 Working capital financing = 15,385 + 9,231 - 4,616 = 20,000
In this example, sales are 10,256 each month and the working capital financing needed to fund this level of sales is 20,000.
It can be seen from the above calculation that, providing the sales remain constant, then the level of working capital financing will remain constant.
Seasonal Working Capital
In practice, sales do not remain constant and will vary over time depending on the seasonality of the business. This variation in sales causes a variation in the operating working capital requirements of the business.
As sales increase the amount due from customers (accounts receivable) increases, likewise to accommodate the increase in sales, inventory and therefore the amount due to suppliers (accounts payable) increases. The net effect is that as the sales increases, the working capital requirements increase and vice versa.
Seasonal Working Capital Example
Suppose, due to seasonality, the monthly sales in the above example increases to 23,077. If all other parameters remain the same, then the working capital financing needed will increase as follows.
Accounts receivable = 45 x 23,077 / 30 = 34,615 Inventory = 60 x 23,077 x 45% / 30 = 20,769 Accounts payable = 30 x 23,077 x 45% / 30 = 10,385 Working capital financing = 34,615 + 20,769 - 10,385 = 45,000
The business now needs working capital financing of 45,000, an increase of 25,000 due to the seasonality of its trade.
Depending on seasonality of business, as the level of sales changes, the level of working capital will change as shown in the diagram below.
In the example shown, the working capital requirement is lowest at the start of the year at 20,000. As the year progresses the sales increase to due seasonality, and the level of working capital needed rises to 45,000 at the mid-point of the year.
In the second half of the year the sales fall back to their normal level and the working capital financing requirement follows down to 20,000. Assuming the business is not growing, the pattern repeats itself in the second year.
The working capital needed at the lowest level of sales is 20,000, and is referred to in the diagram as permanent working capital (red line), as it is always required. The additional working capital needed as a result of seasonal variations (blue line), is referred to as temporary working capital or short term working capital, as it is only needed at certain points throughout the year.
Seasonal Working Capital in the Growing Business
In the above example it was assumed that the business was not growing. If the underlying sales of the business are growing then the level of permanent working capital will also increase as shown in the diagram below.
In this case, as the business grows the underlying sales grow, resulting in a gradually increasing level of permanent working capital, as well as the usual seasonal variation in temporary working capital.
It can be seen above that a business has a base level of permanent working capital financing which is always needed, and a temporary working capital requirement which depends on the seasonality of its trade.
Faced with this situation, the business now needs to decide on a strategy to fund its working capital requirements using short and long term funding sources.
Short and Long Term Working Capital Financing
Short term finance is normally cheaper and more flexible than long term finance. Unfortunately, short term finance is inherently more risky in that it may be withdrawn at short notice and subject to variations in interest rates.
Suppose for example, the business described above can obtain short term funding at a rate of 5%, and long term funding at a rate of 7%.
Using short term funding with the flexibility to only use the amount needed at any given time, the cost of using short to finance is as follows.
Average requirement = (20,000 + (45,000-20,000)/2) = 32,500 Finance cost = 5% x 32,500 = 1,625
If however, the business chooses to use long term finance, this flexibility is lost. The business must now ensure it has the maximum facility (45,000) at all times to fund its working capital financing requirements. The finance cost is calculated as follows.
Requirement = 45,000 Finance cost = 7% x 45,000 = 3,150
Oh course in this instance, surplus cash could be reinvested, however the fact remains that short term working capital financing is generally cheaper and more flexible to use than long term working capital financing.
There is however a major problem with simply using the cheapest option. With long term financing, the business is secure in the knowledge that it will have the funding to finance its working capital requirements and will usually not be subject to variations in interest rates. However, with short term financing the business could have the facility withdrawn or capped at very short notice and be subject to variations in the interest rates.
Working Capital Financing Strategies
In order to establish its working capital financing strategy, the business needs to decide on its attitude to risk, this will determine whether it chooses to use short term finance, long term finance, or a combination of both, to fund its working capital requirements.
The decision as to how to finance working capital generally falls into one of three approaches.
An aggressive working capital financing approach seeks to reduce the financing cost by using short term funding sources to finance both permanent and temporary working capital.
As we have seen above, this approach reduces the finance cost as interest rates tend to be cheaper and its flexibility allows the business to only use the facility when needed. The short term funding facility used will rise and fall in line with changes in the level of sales and working capital requirements.
The downside of this aggressive approach is that by its nature, the short term facility can be withdrawn at short notice, increasing the risk of liquidity and cash flow problems for the business.
A conservative working capital financing approach seeks to lower the risks involved by using long term funds to finance the working capital requirements. By doing so the business ensures that the maximum working capital financing required is available throughout the year, and that the interest rate for the use of those funds is relatively stable.
The downside of this conservative approach is that as the facility does not have the flexibility to be varied in the short term, it needs to cover the maximum seasonal variation in working capital at all times, and is therefore more expensive that the aggressive approach.
A moderate approach or hedging approach to the financing of working capital is a balance between the aggressive and conservative approaches. The business uses a combination of both short and long term finance to fund its working capital with the exact levels depending on its particular attitude to risk and reward.
A typical moderate approach is to fund the permanent level of working capital (shown by the red line in the diagrams above) using long term finance such as equity or long term loans, and the temporary working capital caused by seasonal variations in sales (shown by the blue line in the diagrams above), using short term funding such as short term loans and overdraft facilities.
Using this approach in the no growth example above, long term funding would be used to finance the permanent working capital of 20,000, and a additional short term facility of 25,000 would be made available to allow for the seasonal variations.
Using the moderate approach, the finance cost can be estimated as follows.
Permanent working capital Working capital funding = 20,000 Finance cost = 7% x 20,000 = 1,400 Temporary working capital Average working capital funding = 25,000 /2 = 12,500 Finance cost = 5% x 12,500 = 625 Total finance cost = 1,400 + 625 = 2,025
Using the moderate approach, the total finance cost of 2,025 lies between the aggressive approach (1,625) and the conservative approach (3,025). In addition, the business has the comfort that its permanent working capital (20,000) is funded by a long term source and is not subject to being withdrawn at short notice, while its temporary requirements (maximum 25,000) retain the benefits of flexibility and lower interest rates.
It should be noted that in the case of a growing business, the level of permanent working capital increases over time. In order to allow for this, an average permanent working capital level can be calculated, which is then funded by long term finance, with the balance being covered by short term financing. In the with growth diagram above, the permanent working capital increases from 20,000 to 36,000, and a typical approach would be to establish a long term funding facility averaging at 28,000 throughout the period.