Not all corporate finance is about funding growth or capital investment. Sometimes it’s simply a matter of raising the capital needed to trade through business cycles. But what are the best and most cost-effective ways of raising working capital, and how do businesses avoid overextending themselves?
EY Ireland debt advisory partner David Martin says businesses have to continually monitor their working capital requirements and, in many cases, have to raise working capital finance to help support trade through business cycles.
“When raising working capital funding, businesses need to structure their funding to account for seasonality of their business and also allow a buffer for the various fluctuations that can impact liquidity, such as labour, supply and tax,” says Martin.
According to Brian Fennelly, debt and capital advisory partner with Deloitte, the extent of working capital funding required will vary greatly from business to business and from industry to industry.
“Businesses that are required to continuously hold inventory, such as raw materials, work-in-progress stock or completed goods, or those that allow their customers to purchase their goods or services on trade credit, will have greater working capital funding requirements than businesses which hold minimal, if any, stock levels or receive payment upon delivery of their product or service by their customers,” says Fennelly.
Sometimes this working capital can be funded by a company’s own cash resources, Fennelly notes, but often businesses seek to raise an element of working capital financing to support their working capital funding needs and provide greater trading protection.
In order to determine the nature and extent of any working capital financing requirement, he says businesses should first prepare a conservative set of financial projections underpinned by prudent assumptions based on historical trends — for example, stock, trade debtor and trade creditor days.
“While we would recommend projections are prepared on a monthly basis, management teams should remain conscious of intra-month liquidity requirements – for example, creditors are paid in the middle of the month, while trade debtors typically pay in the last week of the month,” says Fennelly.
Numerous working capital financing options are available to businesses in the Irish market. These range from traditional overdrafts and invoice discounting to bespoke stock financing, revolving credit facilities, purchase order financing and speciality forms of trade receivables financing, including non-recourse financing and securitisations.
“We work with our clients to determine which working capital financing options are most appropriate,” says Fennelly. “This involves a consideration of variables including the cost and complexity of each financing option and their strategic fit for our clients.”
Invoice discounting is a common form of working capital financing utilised by Irish SMEs and is typically, where appropriate, the most cost effective, says Fennelly. It involves a lender providing financing based on a borrower’s book of debtors, with unpaid invoices sold at a discount.
“There are also asset-based lenders and specialist funders who have been very competitive and innovative in providing inventory financing, depending on the nature of the underlying stock item being funded,” adds Fennelly.
Businesses also have more choice than before when it comes to seeking out working capital.
“One of the real positives of the current market is the amount of new working capital specialist lenders, both domestic and international, that are operating in Ireland,” says Martin. “As a result of this, businesses are able to work with their adviser to ensure appropriate structures, minimise cost of capital and ensure they are choosing a capital provider who has a product that best matches their funding requirements.”
Revolving credit is also becoming increasingly popular; it is a flexible funding option that enables businesses to withdraw credit when required.
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.
“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,” says Fennelly. “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 a number of forms of working capital funding in its financing package.”
Martin adds: “Each business we deal with tends to have a unique asset classification thus delivering different options on which you can leverage assets in order to run and grow your business. Many businesses will have suitable debtors and stock which can be used for leverage purposes. Businesses should run scenarios to ensure the appropriate working capital products are used in order to preserve cash.”
Although procuring working capital can be straightforward, businesses should be aware of the pitfalls.
“Too often we see borrowers utilise working capital facilities to fund longer-term projects, ones where term debt financing is more appropriate, which results in ‘hard drawings’ that are typically challenging to unwind and reduce the company’s liquidity headroom,” says Fennelly.
It is also important, he adds, to consider the “committed versus uncommitted” nature of any working capital facilities — overdraft and invoice discounting facilities are usually on-demand or uncommitted forms of working capital financing, and though this is unusual, could theoretically be unilaterally withdrawn or reduced by a lender. Revolving credit, on the other hand, is a committed form of funding and thus more reliable.
Martin points out that there is no “universal” financing solution.
“Businesses should adapt based on their industry, business size, working capital turnover ratio and financial goals,” he says. “Each business will have different risk appetites and this is often an important dynamic when raising funding.
“But an effective working capital management strategy helps businesses not only cover their financial obligations but also boost their earnings.”