What’s the true cost of financing your own working capital?

In this week's edition of The Two Cents Newsletter, Two's Co-Founder & Strategic Sales Manager Ed Brandler explores the true cost of financing your own working capital!

Selling B2B is tough.

Like you, your buyers have inventory to acquire, employees to pay, and investors to satisfy…

Businesses all too often find themselves obliged to subsidise their customers’ purchases.

Multiply that across the whole supply chain - with each upstream supplier having to offer terms in turn to its buyers on and on up the chain. The same often happens when buying a home.

The collapse of one sale can cascade across the entire sequence, bringing all the transactions down with it. And with each party having to wait on the next one to complete its transaction, the longer the chain, the greater the complexity, and the larger the risks.

But the reality is that in B2B, merchants rarely have a choice.

Let's get our definitions straight

It’s worth briefly defining working capital.?

You can think of working capital as a financial metric that assesses a company's short-term liquidity and operational efficiency. It represents the resources available to fund a company's day-to-day operations and meet its short-term obligations.

In practical terms, working capital is calculated by subtracting a company's current liabilities (such as short-term debts and upcoming payments) from its current assets (like? cash, accounts receivable, and inventory).

The resulting figure reflects the net amount of liquid assets that a business has at its disposal … or lack of. And of course that means the business needs to? fund from elsewhere.

Having a healthy working capital is crucial for the smooth functioning of a business. It ensures that the company has enough financial cushion to pay for its immediate expenses, such as purchasing inventory, covering employee salaries, managing utility bills, and meeting other short-term obligations.

So what does working capital cost?

There’s no getting around the requirement for working capital. But how do we measure what it truly costs?

First, we should consider the opportunity cost of using capital to finance working capital needs. The cost of capital represents the return a company could have earned if the capital had been invested elsewhere, and is broadly called the “Cost of Capital” - the expense a company incurs to finance its operations through equity and debt sources.

To put it another way, the cost of capital is what investors expect you to return to them - at the bare minimum.

What this means is that any of the company’s money spent on literally anything should return at least the cost of capital. That includes the activities that fall under working capital.

Here’s an example.?

You are a startup and your cost of capital is 20% (a fairly standard amount for a risky startup), and you have the option to fund your working capital at 10% by borrowing from a lender. What should you do???

You should absolutely borrow that money. It’s a freebie. It’s like refinancing your credit card for a lower rate.

That’s of course, assuming you can find a lender.

Non-Cash Ways to Improve Working Capital

There are two sides to the working capital coin: the money you lend, and the money you borrow. Lending less, and borrowing more, is one way to do this without seeking explicit funding.

If you can get 90 days terms from a supplier, and offer 30 days terms to your buyers (and they pay on time!), you’re in the happy position of having what we call Negative Net Working Capital.

But this means essentially pushing the cost of your working capital onto your suppliers and buyers. This isn’t always easy, and it tends to make you unpopular. If you aren’t in a position to stretch your terms on either side of the supply chain, you may want to consider looking elsewhere for funding.

External Sources of Working Capital Financing

There are five key sources of external financing for a merchant’s working capital.

Credit Cards: Business credit cards allow companies to make purchases and access short-term funds, providing a convenient and flexible way to finance working capital needs. They offer a revolving line of credit that can be used for various expenses. At the same time, a merchant taking credit card payments gets paid upfront, reducing their Accounts Receivables balance and shortening the working capital cycle.?

The cost to merchants to process corporate credit card transactions is typically in the 2 to 2.5% range.

Factoring: Factoring involves selling unpaid customer invoices to a third-party factor at a discounted rate. It provides immediate cash flow by converting unpaid invoices into immediate funds, helping businesses manage their working capital requirements.

The headline cost of factoring can generally vary between 1.5% and 5%. But there’s a catch - Factoring companies typically only fund 80% of an invoice. The rest has to come from the merchant’s equity which is priced at their cost of capital. So a blended rate needs to be applied to the overall cost. Here’s an example:

Of course, the remaining €2,000 still needs to come out of your own pocket until the invoice is paid.

B2B Payments: Business-to-business (B2B) payment solutions streamline the payment process between companies. They can include electronic payment methods, such as ACH transfers, wire transfers, or online payment platforms (like Two), facilitating efficient and timely cash flow for both buyers and sellers.

Keep reading until the end because we go into this in more detail in a bit!

Revolving Credit: Revolving credit facilities, such as lines of credit or overdrafts, provide businesses with a predetermined credit limit from which they can borrow and repay multiple times. It offers flexibility and quick access to funds, making it suitable for managing short-term working capital needs.

Let’s look at a quick example.?

Suppose a business obtains a revolving credit line of ￡100,000 from a lender. The lender charges an annual interest rate of 10% on the outstanding balance and imposes an additional 2% fee on the unused portion of the credit line.

In this case, let's assume that the business borrows ￡50,000 from the credit line and keeps the remaining ￡50,000 unused. The calculation would be as follows:

Interest Cost: The interest cost is calculated based on the borrowed amount. So, the interest on the ￡50,000 borrowed would be 10% of ￡50,000, which equals ￡5,000.

Fee Cost: The fee cost is calculated based on the unused portion of the credit line. In this example, the unused portion is ￡50,000. The fee would be 2% of ￡50,000, which equals ￡1,000.

Total Cost: To find the total cost, we sum the interest cost and the fee cost. In this case, the total cost would be ￡5,000 (interest cost) + ￡1,000 (fee cost), resulting in a total cost of ￡6,000.

Working Capital Facilities: Working capital facilities are specialised financial products tailored to meet the short-term financing needs of businesses. They provide access to funds specifically for working capital requirements, such as purchasing inventory, managing cash flow, or covering operational expenses.

What about B2B BNPL?

Enter the promise land of B2B BNPL…

A simple way of accessing tied up working capital is to avoid waiting for invoice payments in the first place.

One of the main limitations of offering trade credit is that you’re forced to wait for the money you’re owed. And in the meantime, your bills still need paying…

B2B BNPL on the other hand provides the seller with payment upfront for sales made on trade credit. This of course drastically improves cash flow and allows far more flexibility as your business grows.

Take Two for example.

Two’s payment technology enables businesses across all industries to offer purchasing on invoice, providing a frictionless checkout experience with instantly approved credit. Using Two, you can simplify the payment journey to access working capital and increase B2B sales while reducing time consuming operational work.

Whether you want to supercharge your B2B e-commerce checkout, optimise your trade account for frictionless customer onboarding, or offer B2B BNPL on all sales channels - Two is here to help.

So, the bottom line here is: there are many financing options available. But B2B BNPL platforms like Two enable businesses to access working capital with the need for bank loans, lines of credit, or selling your outstanding invoices for a cost.

If you'd like to learn more about how Two can improve everything from cash flow and increased B2B sales to reduced admin and credit risk, be sure to talk to one of our experts!