Working Capital and Growth
Growth is usually treated as an uncomplicated success story. A business wins a larger customer, demand increases and sales begin to rise. On paper, the company is doing exactly what it is supposed to do.
But growth changes more than revenue. It can also increase the amount of stock that needs to be purchased, the amount of cash committed to logistics and distribution, and the length of time that money remains tied up before the customer pays.
That creates an interesting problem for growing SMEs. The business may be commercially stronger than it was before, while simultaneously requiring more working capital than its existing balance sheet can support.
A simple example helps explain why.
A Growing SME With a Strong Customer
Consider an SME supplying hardware products to a large retail chain.
The business imports the required goods, receives and stores them at its warehouse, packages them for distribution and delivers them to the retailer’s central collection depots. Once the goods are accepted and a Goods Received Note is issued, the SME invoices the retailer.
In the original trading cycle, the SME allows approximately 30 days for importation and receipt into its warehouse, another 15 days for packaging and distribution, and 15 days for the retailer to pay after invoicing.
That creates a total working-capital cycle of roughly 60 days. For those 60 days, the SME needs sufficient liquidity to support the trade before the cash invested in the transaction returns.
Then Demand Increases
Now imagine that the retail chain expands.
More stores mean greater demand for the SME’s products, which should be good news. The supplier has a larger customer, a larger order book and the potential for higher turnover and profit.
But two things happen at the same time.
The SME has to purchase and finance a greater volume of inventory, while the retailer also changes its payment terms from 15 days to 30 days.
The physical trading cycle has not disappeared. The goods still have to be imported, stored, packaged and distributed. The difference is that more stock now has to move through the cycle and the SME waits longer to be paid.
The working-capital cycle therefore stretches from approximately 60 days to 75 days. The business has grown, but so has the amount of capital required to support it.
The Catch-22 of Growth
This is where an apparently positive commercial development can create a financing constraint.
The SME approaches its bank or existing financier for a larger working-capital facility. Conventional lending, however, may still be governed by limits linked to the company’s balance sheet, capital base and existing borrowing capacity.
The business may be able to demonstrate a valid supply agreement, a credible retail off-taker, clear expected cash flows and a genuine ability to repay the facility from the underlying trade. Yet the amount it can borrow may still be limited by the size of the balance sheet it has today.
That creates the catch-22.
The increased orders should generate more turnover and profit, which should eventually strengthen the SME’s capital base. But the business first needs enough working capital to execute those larger orders.
The growth that could strengthen the balance sheet is being constrained by the balance sheet itself.
Looking at the Trade, Not Only the Balance Sheet
Structured trade finance approaches this problem from a different starting point.
The balance sheet still matters. So do the company’s track record, management capability and ability to perform the contract. But the underlying transaction is also examined in detail.
What goods are being financed? Who is buying them? How does the product move from procurement to delivery? Where are the goods stored? When does payment fall due? What contractual cash flows exist? What controls can be put around the transaction?
The purpose is to understand whether the trade itself can support the financing.
In this example, a structured trade financier would assess the complete supply chain, the quality of the retail off-taker, the contractual cash flows, the goods being financed and the mechanisms available to control and mitigate the relevant risks. The underlying trade, assets and associated cash flows become an important part of both repayment and security.
Understanding the Complete Trading Cycle
That means following the transaction from beginning to end.
The financier needs visibility over sourcing and procurement, importation, freight and logistics, customs clearance, warehousing, packaging, distribution and final delivery to the retailer.
The quality of the off-taker also matters, as do any mechanisms supporting payment, which may include a confirmed purchase order, payment undertaking, credit insurance, Letter of Credit or another appropriate form of credit enhancement.
This is not simply about finding a different way to lend money. It is about understanding where the money goes, what happens to the goods while capital is deployed and how cash ultimately returns.
How the Funding Cycle Is Assessed
The funding requirement is not determined simply by the value of the order. It is shaped by how much capital is required at each stage of the trade and how long that capital remains committed.
In this example, the SME initially needs to finance approximately 60 days between importing the goods and receiving payment. Once volumes increase and the customer extends its payment terms, that cycle stretches to around 75 days.
The financier therefore needs to understand not only how much funding is required, but when it is required, how long it remains deployed and when cash is expected to return.
This funding cycle becomes part of the structure of the transaction itself. A longer cycle or larger volume can materially increase the amount of working capital required even when the underlying commercial opportunity remains sound.
The SME Still Has to Stand Up to Scrutiny
Structured trade finance does not remove the need for due diligence.
The SME’s reputation, experience, management capability, financial position and ability to execute the proposed transaction still need to be assessed. The financier also needs to understand whether the business can remain profitable, liquid and solvent throughout the financing period.
The difference is that the assessment does not stop with the balance sheet.
The transaction itself becomes part of the credit story.
Mapping the Risks and the Mitigants
Once the trade has been understood, the next step is to identify where the risks sit.
These may include commercial risk, operational risk, logistics risk and counterparty risk. The important point is that each risk is considered together with the mechanism available to control or reduce it.
Depending on the transaction, those mitigants may include marine and cargo insurance, comprehensive asset insurance, credit insurance, control over the movement and storage of goods, assignment of contractual rights and receivables, and controlled collection accounts.
The objective is not to suggest that every risk can be removed. It is to understand which risks exist, determine which can be mitigated and assess whether the remaining risk can be accommodated within the financing structure.
Control Over the Goods and Cash Flows
Another important feature of structured trade finance is the level of control the financier can maintain over the underlying goods and associated receivables during the transaction.
Depending on the structure, this may involve contractual arrangements, security instruments, title or ownership structures, control of documents, warehouse arrangements, assignments and controlled payment mechanisms.
These controls help ensure that the financier has appropriate visibility over the assets being financed and the cash flows expected to repay the facility.
How Repayment Is Structured
A central principle of structured trade finance is that repayment should come from the underlying transaction itself.
The goods, contractual cash flows, off-taker and receivables all form part of understanding how capital is expected to return to the financier.
The structure may therefore include assignments, controlled collection accounts, document control, warehouse arrangements or other mechanisms that provide visibility over the assets and cash flows supporting repayment.
In other words, the financier is not relying only on the SME’s general balance sheet. The financing is structured so that the trade itself provides an identifiable route to repayment.
Financing Growth Before the Balance Sheet Catches Up
This brings us back to the SME with the expanding retail customer.
Its problem is not a lack of demand.
It has the customer, the supply agreement and the opportunity to grow.
The challenge is that growth has increased both the volume of stock it needs to finance and the time it has to wait before receiving payment.
Structured trade finance can potentially allow the financier to look beyond the existing balance sheet and assess the underlying trade, assets, contractual cash flows, off-taker and risk controls supporting the transaction.
That can help bridge the period between the commercial opportunity arriving and the SME’s balance sheet having had time to catch up with it.
Growth still has to be profitable. The customer still has to be credible. The funding cycle still has to make sense. Risks still need to be understood and mitigated, and there must be a clear route to repayment.
But where those elements can be brought together appropriately, a business should not necessarily have to wait for its balance sheet to grow before it can take advantage of genuine, contract-backed demand.
That is where structured trade finance can help turn growth from a working-capital constraint into an executable commercial opportunity.
Friday 2 October
