If you were to speak to small business owners about the things that occupy the biggest chunk of their time and attention, the vast majority will include working capital management in their list. For smaller businesses, cash is the undisputed king.
It is impossible to overstate the importance of effective working capital management for an SME. Lack of it could not only disrupt the smooth functioning of business, but also result in delayed payment of trade dues as well as salaries, which could lead to loss of reputation and drop in employee morale. That’s why effective cash flow management could make the difference between survival and shutting down.
If you are a small business owner, here are a few tools for working capital management that you will find in most business courses.
- Bank Overdraft: As the name suggests, this is a facility offered by banks whereby account holders are permitted to draw money beyond the balance in their account, up to an approved limit, known as the overdraft limit. For example, an account holder having AUD 7,000 in the bank, with an overdraft limit of AUD 5,000 can draw up to AUD 12,000.
Where the overdraft facility is availed, interest is charged only on the overdrawn amount. Unlike a loan, which comes with a repayment schedule, overdraft offers considerable flexibility as far as the timing of repayment is concerned. However, given the cost of borrowing, this facility should be used only if absolutely needed. As of 2016, overdraft charges in the United States amounted to a whopping USD 11.6 Billion.
- Factoring: Factoring is an arrangement with a financial intermediary (known as a factor), whereby businesses can sell invoices on which payments are receivable on a future date in return for liquid cash. For instance, a company in need of liquid cash may sell an invoice against which AUD 100 are due in a month’s time. The factor will pay, say AUD 70 in cash up front. On receiving payment from the debtor, the factor will retain, say AUD 5 and transfer the remaining AUD 25 to the company.
Invoice factoring is best suited for companies which are in industries where there is usually a long period between raising the invoice and receiving payment, or those which are in urgent need of cash, because it is a relatively expensive form of working capital financing.
- Bills of exchange: Bill of exchange is a financial instrument commonly used in international trade, whereby one party undertakes to pay a certain amount to the other party, usually on a specified date. What makes it particularly useful as a financial instrument useful is that the drawer (i.e. the party to whom payment is due) can transfer legal title to the bill of exchange to a third person, which means payments can be made even before cash is received.
In addition, the payee has the option of encashing the bill of exchange by endorsing it to a financial institution, which will apply a discount plus service charges, based on its policies (referred to as discounting). While discounting eliminates default risks, it is also an expensive method of financing.