Sources of Working Capital a Top Challenge for Companies

Securing reliable working capital in sufficient amounts is usually the top business challenge today for companies with revenues of $2–200 million. Viewed from a macro level, working capital constriction for this group of companies is a significant problem for the U.S. economy as a whole.  Businesses of $2–200 million in revenue account for roughly two-thirds of private sector workers and 45% of business revenues in the U.S. according to U.S. Census data, yet less than 5% of capital markets activity is devoted to funding them,  leaving a substantial financing gap.  And that gap has only increased during the global financial crisis, which has further restricted access to capital — which has increased the risk of becoming unsustainable for some businesses.

A major source of working capital anxiety is the trend toward large companies demanding extended payment terms from their suppliers.  Extending payment terms has a direct negative impact on a company’s cash conversion cycle and dramatically increases the need for additional working capital. Until  small and mid-sized companies find ways to shorten days sales outstanding (DSO),  this issue is likely  to persist,  as cash- strapped and large customers extend their  payment terms further.

The Value of a Cash Cushion

Restricted access to capital can stand in the way of growth or force an adjustment to day-to-day operations. Perhaps that is why companies view having a strategic “cash cushion” as very important to their business. Top uses for cash cushion include coping with disruptive events, being in a position to take advantage of business opportunities, dealing with seasonality and slow-paying customers or customers extending terms.

Because they often lack a sufficient cash cushion, small and mid-sized companies are particularly vulnerable to business disruption, which can be sudden and extreme.  This vulnerability is exacerbated by today’s tightly woven supply chain, where business woes anywhere along the chain have significant “ripple effects” both upstream and downstream.  Business uncertainty can create opportunity for companies that are prepared, but they must have resources on hand to seize that opportunity.  This is easier said than done.

Working Capital is a Distraction

All of these working capital pressures add up to a major distraction for most companies in this revenue range.  Working capital challenges create excessive anxiety at their companies and lessen the sense of control when it comes to their company’s finances.  Only about 25% of companies are satisfied with their company’s current strategic cash reserves.  Having cash to make payroll is a frequent concern for many of companies.

Considering the level of angst over working capital issues, it is not surprising that the majority of businesses consider cash flow a key driver of their business and CFOs spend “a lot of time” researching and educating themselves about how to best manage working capital.  Working capital and cash flow management disciplines should be proactive during good times and not an emergency exercise when cash flow issues become a problem.

Seeking Financial Alternatives

Until recently, many companies comfortably relied on traditional financing sources such as bank lines, asset-based lending or factoring to source working capital. But small and mid-sized companies are losing confidence in traditional financing as access to capital has become more restricted. In fact, many small and mid-sized companies are increasingly blocked out of traditional financing sources that are now open only to very large companies. Many companies have been forced by the current economic situation to consider alternative forms of financing they had not previously considered. Events most likely to trigger companies to seek new financing include project financing (i.e., funding a major piece of new business) and disruptive events (bank cutting line of credit, sudden expense and major customer extending terms).

However, funding overall growth was cited as a reason to seek financing by a most companies, which would seem to indicate a deeper, more systemic issue with working capital access for companies of $2–200 million in revenue.  Unfortunately, at least half of all companies that applied for bank financing in the last 12 months were turned down.  The trend towards alternative financing may be driven by more than just restricted availability of traditional financing. Diversification of funding sources has traditionally not been a major issue for companies in this size range, and yet more companies have concerns about “putting all their eggs with a single financing source”, and diversification of funding sources has become of strategic importance to companies.

Even though the majority of companies in the $2- $200 million revenue range have lines of credit, for many of these companies their bank lines of credit are not sufficient to cover their working capital needs, creating a need to seek financing options in addition to their line of credit. Indeed, banks are a key source of working capital for a large number of companies, but tightening in credit markets has led many companies to augment their lines with complimentary sources of liquidity. Given these widespread trends in the marketplace and the accompanying credit climate, small and mid-sized businesses are turning to alternate financing sources in record numbers.

Looking to the Future

As the U.S. economy continues its slow, uneven growth, ensuring sufficient access to capital at a reasonable cost will remain a significant challenge. The prospect for these broader working capital issues resolving themselves is low. As small and mid-sized companies continue to recover from the economic crisis, they will need to manage risk more effectively. This means optimizing cash conversion and diversifying funding sources.  Managing these risks is vital, not only to short-term profitability, but also to overall financial health and long-term sustainability for small and mid-sized businesses.  Harvest CFO Consulting will help your company to instill working capital discipline and seek financing alternatives to create competitive advantage and create an optimal working capital structure.

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