Welcome to the third post in our series: "Small Business Financing: What You Need to Know." In the first two posts, I covered what you need to know about small business financing followed by how to align your funding sources with your funding needs. In this post, I'll focus on alternative sources for working capital.
What Is Working Capital?
Working capital is much more than the common, widespread definition ("current assets minus current liabilities") implies. In reality, this capital is about liquidity, which means having access to cash when you need it. By routinely forecasting cash flow, you can determine when cash is flowing into your business (receipts) and when cash is flowing out (disbursements). The more cash flows in, the more working capital you have to fund venture growth.
Alternative Sources for Working Capital
Here are eight alternative approaches to increasing working capital beyond traditional bank financing:
- Business Profits
By minimizing your costs and maximizing your sales and profit margins, you can contribute to your company's healthy profits. These profits provide healthy sources of working capital funding.
- Personal Resources
Many startups leverage personal resources such as cash, retirement funds, second mortgages and credit card advances. The key to success when you're using these alternative sources for working capital is ensuring the biggest bang for your buck. After all, these resources are limited.
- Trade Credit
Payment terms extended by suppliers essentially represent an interest-free loan: You receive the goods and services and pay for them in 30 days, 60 days, 90 days or more. In short, the working capital remains in your control and your use until the invoice is due. Maintaining good payment practices leads to longer and more favorable terms (more working capital) over time.
- Line of Credit
Drawing from a specific amount of credit extended by a financial institution offers flexibility in working capital. This can be particularly useful for seasonal businesses that gear up on inventory levels at different times of the year. The rate of interest charged can be higher than a fixed loan and the total amount of credit extended is typically paid down to zero once within each 12-month period.
- Merchant Services Advance (MSA)
If your business accepts credit cards as forms of payment, a two-year track record of sufficient receipts can provide you with access to working capital advances that are satisfied as a percentage of future credit card sales.
- Purchase Order Financing
When your business has a valid purchase order from a financially solid customer but you lack the funds (working capital) to fill the order, a purchase order financing company can advance funds against the total purchase order value.
- Quick Pay Discounts
When you offer your customers a quick pay discount, such as 2 percent 10/net 30, you provide them with an incentive (2 percent off) to pay you sooner rather than later.
- Accounts Receivable Invoice Factoring
Factoring is like selling a product at a discount. The product is the invoice and the discount is the rate paid to convert the invoice into working capital (cash in hand) sooner — typically 24 to 48 hours — rather than later, when the invoice becomes due — possibly 30 or 60 days. I'll talk more about this alternative source to working capital in my next blog post.
The Best Alternative
The best alternative source for working capital funding is the one that serves the needs of your business. In an effort to choose the best source for you, you should start with routine cash flow forecasting. When it becomes clear that a cash flow shortfall is ahead, these alternative funding sources can come in handy.
In my next article in this small business financing series, I'll take a more in-depth look at invoice factoring: the myths, the pros and the cons. When in doubt, consult with your own tax and/or legal professional who will be able to offer advice based on your specific circumstances.
Read the rest of the series.
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