All businesses have some sort of an operating cycle. This is essentially the time it takes from purchasing needed materials or supplies and converting them into a finished product that can be sold. The operating cycle further consists of selling those products and collecting payment for all that effort. Once products are sold and payments collected, the cycle is completed.
For retail businesses (including online businesses) the cycle starts with purchasing products for resale (inventory) then displaying those products on shelves or on web pages, closing the sale and collecting payment.
Even service businesses, while their operating cycle can be much shorter, still see a time lag between providing the service (to include any purchases of material or labor to complete the job) and collecting payments from customers.
It is because of this time lag that working capital financing comes into play.
All these businesses need some form of assets, be it inventory, materials, supplies, labor, etc. (usually termed: current assets) that can quickly flow through the operating cycle and be converted into cash (revenue). This is essentially what business is. Once payment (revenue) is received, the company can then use any operating cycle profits (gross margin) to cover overhead expenses like salaries, marketing, loan payments and interest, capital purchases, or any fixed general, administration or selling expenses.
The problem that arises for most businesses (especially small and growing businesses) is not having the cash on hand to purchase the needed materials to complete their operating cycle. Not only do some businesses not have the cash or capital to purchase needed materials they may also not be able to cover other variable costs related to the operating cycle like paying labor, landlords, utilities, etc.
In a perfect world, all businesses would have the necessary financial wherewithal to cover all expense while waiting for payment. But, the business world is not perfect. Most businesses have to wait anywhere from one day to years to complete their cycles and get paid by their customers (typical operating cycles usually last from a few weeks to a few months but depend on the industry and business).
But, in the mean time, while these businesses transform goods into finished products or services and wait to be paid by their customers (or wait to see if they can even sell the products or services they offer), their suppliers and vendors, landlords, utility companies, employees, IRS, bankers, etc. all want to be paid now and not wait for the business to receive payments as they are also facing their own time lag in their operating cycles. Thus, for businesses that do not have the cash on hand to meet these expenses, they must turn to working capital financing or face going out of business.
Working Capital, by definition, is the difference between current assets and current liabilities where current liabilities are used to finance current assets; and the conversion of those current assets into revenue is what is used to pay off those current liabilities.
Example: A manufacture of ball point pens finances the purchase of plastic pellets needed to mold the pen's casings. The manufacture then adds value to this inventory of raw material (pellets) by making the pens and shipping them to a customer. Once payment is received from the customer, the manufacture uses part of this payment to pay off the financier or creditor and keeps the difference to cover its other variable and fixed costs.
Therefore, the manufacture converted these financed raw materials into cash to cover the financing and earn a profit.
The same process can happen in both retail and service businesses as these businesses also need to purchase inventory (stock) to resale or purchase supplies and pay labor to provide a service. But, once the job or sale is completed (after some time lag) and payment is collected, these funds can be used to pay off any needed financing.
As a side note, even if the business does have the wherewithal to cover its current assets from its own retained earning - it might not want to. For one, it is better to purchase an asset that will pay for its self and two, retaining needed cash in a business may have more positive impact if used for growth, expansion, and development - making the business stronger in the long-run.
There are many methods to working capital financing; here are a few of the most common:
Trade Credit: The fastest and most efficient way to finance materials or supply is via trade credit. How it works is simple. You purchase goods from your vendors or suppliers. They tell you that you can delay payment for those goods for 60 days. This 60 day period will give your business time to convert those goods, via your operating cycle, into revenue in which to repay the vendor or supplier. If you are not currently getting trade credit terms from your vendors - you might think about asking for them. If you are, you might look into getting them extended. The longer the payment delay terms, the better for your business.
Business Lines of Credit (BLOC): BLOCs are short term revolving credit lines (usually with a 12 month or less term) and are specifically designed for working capital needs. These credit lines allow businesses to purchase needed material, supplies, labor etc., convert those into some form of revenue over a very short period and pay back the borrowed funds as soon as possible. BLOCs are usually revolving lines meaning the business can pay them down from one operating cycles and draw on the line again for another operating cycle. Most BLOCs are set for 12 month periods as these lines are meant for short-term financing only and from a banker's prospective should be paid to zero some time during the business's operating cycle.
Business Cash Advances: These cash advances are not loans but advance against future sales. These advances are great methods of working capital financing as they allow businesses to receive capital up front and pay it back from future sales. Business cash advances are usually based on the total revenue of the business but do require the business to accept credit cards as payments from their customers - as it is these credit cards receipts that are used to pay back the advance. Business Cash Advances are very good working capital products for retail (online and brink and mortar) as well as service businesses.
Accounts Receivable Factoring: Some businesses may find themselves in (according to baseball terms) as pickle - stuck between waiting for customers to pay on one side and having trade partners (vendors and suppliers) demanding payment on the other side. Let's say your business purchases materials Net 10 days - meaning that you have 10 days to pay in full for those materials. You convert those goods into finished products in 5 days and ship them to your customer with a NET 30 day invoice - meaning your customer has 30 days to pay you. In these situations, Accounts Receivable Factoring can be used to obtain the working capital needed to pay off the supplier as well as purchase additional materials for another operating cycle. Then, when payment is received by your customer, the business can repay the Accounts Receivable loan or line of credit and use the remaining gross margin profits to cover other costs and overheads. Most factoring company will advance 80% of the invoice amount and base their approval decisions on your customer's creditworthiness.
(NOTE: it would be financial better, in the long-run, for the business to match its payment days (Net 10) with its collection days (Net 30) by either asking the supplier to extend its payment time or asking the customer to shorten its payment time or visa versa - if possible. This will save the business any and all financing charges associated with this form of working capital financing.)
Purchase Order Financing: Purchase Order Financing is a great method of securing working capital for a business's operating cycle. Let's say that your business has one or more jobs that need to be completed but finds itself without the needed working capital to complete the job(s). A purchase order factor may advance your business the funds (up to 80% of the purchase order amount) so that you can complete the orders, satisfy your customers and earn a profit.
Lastly, and this cannot be emphasized enough, working capital financing is short-term financing and should only be used for short-term needs. Keep in mind that most operating cycles are very short periods - usually less than 90 days. Thus, any financing to be used in the operating cycles should be short-term. Anything else is bad financial management as the business would be paying far more in interest and fees if it uses long-term financing options for short-term, working capital needs.
There is an old saying that it takes money to make money and in business, especially regarding financing operating cycles, it takes working capital for a business to earn revenue and ultimately earn profits.
Working capital financing is a great means to obtain the money needed to make more money, but if not used properly, can also hinder a business' ability to grow and survive.