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Understanding working capital loans

February 10 2020

Understanding working capital loans

The hardest thing about running a business is managing cashflow. The real problem comes in where customers require credit terms - meaning you only get your money much later after providing the service.  Unfortunately, if you’re a new or small business, you may not be able to get credit from your suppliers - meaning you have to spend the money now and only get paid significantly later. As a result of this, all businesses should know the length of their working capital cycle. This is the time from when your inventory is ready for sale to when you’ve turned that inventory into cash and is represented by the formula:

Inventory Days + Debtors Days - Creditors Days

By way of an example, let’s say that your inventory takes 20 days to sell.  Once sold, it takes 30 days for your customer to pay you. That means that it takes 50 days for you to turn your inventory into cash. If you have to pay your creditors in 30 days, you have a 20-day gap in your working capital. This is a vital number for all small businesses to know as that 20-day gap needs to be financed in some way - either through the owners own capital injection, traditional finance from banks or by not paying your suppliers on time (which can have negative consequences for your supply chain down the line). However, debt is a double-edged sword in that when it is managed well it is able to catapult businesses to the next level, but when managed poorly it can sink a business.

With that in mind, here are 3 tips on how to manage your debt well:

1) Finance specific jobs or projects

If you can, don’t borrow money against sales that may or may not happen.  Borrow once it HAS happened. That way, you can include the cost of borrowing into your cost price. For example, If you have a R10 000 sale that you need to finance at 5% per month, you know your cost is R500.  If it has cost you R4 000 to produce the goods that you sold, your total cost of sale is R4 500. This ensures that you always know exactly what your Gross Profit on any sale is.

2) Don’t borrow money earlier than you need to 

The advantage of financing a specific job or sale (as opposed to a bank overdraft or loan) is that you don’t incur more interest than necessary.  In the previous examples, with a 20-day cash gap, there should be no reason to borrow before you have to pay your suppliers. This means that you can pay interest for 20 days, as opposed to 50 days, thereby keeping costs down.

3) Use the money for the specified purpose

If you’ve financed a specific sale or project, make sure you spend the money to pay the costs associated with that project.  Keeping a tight rein on what you do with borrowed money is the simplest way of making sure that your debt is serving you. The simplest question to ask is “Do I NEED to use this money on this?”  If not, it must be purchased with earned money and not borrowed money.

Investmint is uniquely positioned to assist in providing both invoice factoring and project financing loans and to advise on the best way of structuring these loans to make sure that you’re borrowing the correct amount at the correct time.