Importance of working capital for businesses in a recession

As the reality of recession in US sinks in, businesses need to understand the importance of working capital for survival. Many small businesses fail due to improper working capital management.

The machines, equipments etc., which actually help produce the goods and services are fixed capital. The goods in stock, debts, any advances given to supplier, etc., form the working capital. One key ingredient which distinguishes fixed capital and working is components of working capital keep changing into cash and the cash is again used to buy the original material for reuse. Whereas fixed capital is already spent and you can do very little about it now except when you try to sell the surplus equipments into cash. So for a retail firm selling food articles, the computer they own is a fixed capital but for an electronics retail firm, the computers they hold on stock will be working capital. For the electronics retail firm, any computer held by it for own use (will be

Citibank has been reporting losses to the tune of billions of dollars for many quarters but is still surviving but Lehman Brothers just collapsed. The difference is only one thing, working capital management. An older example of perennially losing organization still surviving is General Motors, which for years has been burning cash. How they have survived, just because of better management of cash (meaning better working capital management).

What Citibank did was dramatic. It understood that once it started reporting losses there will be a run to collect money back by depositors and the various creditors. So it started building up huge mountains of cash raised as share capital or other long term capital early on well before the size of financial melt down happened.

The reason why General Motors is angling for federal funding, as it very well knows, no private organization is going to fund such a dead duck. But how come it was able raise funding so far even with mounting losses. Because it had assets of huge value, the creditors thought that they can seize the assets and sell them to recover their loan with interest. What are the assets I am talking about, it is not the rusting machinery, jigs and fixtures, etc., Of course they can be sold at cut rates and still raise billions of dollars. Instead I am hinting at the valuable real estate, it is sitting on. The real estate was not just working as an asset but also as a threat. Just think about the amount of real estate that will come to the market if GM fails not just from its own holdings but from its failing suppliers, employees, dealers etc., in every market.

But what about the small businesses, many of which don’t own any real estate at all. They find it difficult to raise loans. Most of their fixed capital will be machines and equipments which realize much less cash on a sale. This is one reason why small businesses find it difficult to get loans from banks. Some try getting advances from customers to better manage their cash flows.

Is their any other way of getting outside funding for such organizations? Yes they may get a working capital loan from a bank pledging their machinery, stock and debts. But there are many hassles involved for getting the loan from a bank and servicing it. Some of them are:
1. Requirement of audited balance sheet
2. Detailed stock records
3. Requirement of sureties and guarantees to safeguard the lender
4. Lengthy forms to fill up
5. Most importantly, regular installment payments to be made monthly to pay the interest and also to repay the installment on principal. This is fixed by the lender not the borrower with very little care for the borrower’s cash flow or its seasonality. The bankers are comfortable with a fixed amount of principal repayment along with the periodic interest. Some banks may go a little extra way and get an EMI. But all this affects the borrower’s working capital in a major way, peak in the middle of festival season, just when he is making the sales and will be collecting cash much later. Cash and carry businesses are on a much safer ground as they need not have debts to worry about and can manage their cash flow much better.

Wherever debts are most uncontrollable, it can cause failures of businesses as cash and ability to raise cash dries up. One practical way of handling this is getting a working capital advance from a factor. How it works? You sell the goods at credit and collect a major portion of sold value from a factor. He will reduce a portion for servicing the interest and delayed interest. He will take back the money only when the customer pays it. What this means is that your working capital management becomes much simpler, as you need not worry about the repayment of principal and interest. How, the advance acts as self liquidating? On collection from the customer, you will get the difference between the full collection and the interest and principal.

But this will only work for businesses where debts are a major portion of total working capital. In two situations, it will happen this way. One where stock is minimal and is frequently purchased for cash and the other is when though stock value is significant, stock is bought on credit and the period of repayment of credet is similar to the period of repayment of debt.

Some factors try to mitigate the risk of default by trying to fund the entire supply chain and identifying the ultimate final customer. How this is done? A textile garment goes through many stages. The base raw material is bought on credit by the yarn maker, who in turn sells it to cloth maker. The cloth maker in turn sells to garment maker who in turn supplies to the retailer. If the ultimate buyer from the retailer or the retailer himself is reputable enough then the factor has very little chance of default and easily earn his interest.

As working capital advance from a factor is generally an unsecured advance, there is no need for security from home, business, machinery or inventory. What this means is a much simpler scrutiny and very little or no application fees. The tied up repayment gets a big load off the debt collection work and the small business owner can focus on improving his business and not on sales already completed by him.
Given that it is an unsecured advance, you can spend the proceeds on emergency funding, expand or remodel, pay off expensive debts or taxes, purchase and stock up inventory or even buy new or used equipment.

Many people think their present financial arrangements are pretty comfortable and may well ask why do I need an arrangement like this? As a saying goes, a banker is one who lends you an umbrella when you don’t need one but takes it back when it starts raining. Recession is feared for great troubles and also great opportunities. In both situations you need extra finance. A sudden fall in demand may create a price war with a competitor or the competitor may be willing to sell out if only you could pay cash down to clear his debts. During the great depression of 1930s a small cola company was struggling and offered to sell out to Coco cola. Coco cola refused the offer. The small company did survive the recession to become Pepsi cola of today.

Even if you are comfortable with your finances, you never know which of your customers may get into trouble. Then the extra financing might come in handy.

Summary: Overall always have some extra cash for emergency needs. Reduce any unnecessary expenses but do spend on all essential things promptly. Continuously monitor the latest developments in your little woods for warning signals.