An RBF Framework for Making Credit Decisions

In the landscape of alternative finance, where small businesses often seek capital when traditional banks decline to lend, understanding the working capital cycle is crucial. This financial metric not only provides insights into a company’s operational efficiency but also serves as a more reliable indicator for lending decisions compared to revenue-based financing.

What is “Working Capital”?

The term “Working Capital” is often used casually, but entrepreneurs frequently overlook its deeper significance and the financial metric behind its common usage. Working Capital refers to the operating liquidity that is accessible to businesses and organizations. Below is the formula.

Working Capital = Current Assets – Current Liabilities

At Capital Source, we have daily feasibility discussions with prospective clients, asking questions like, “How do you intend to use our funds?” or “What are your commercial objectives?” and “How can our funds support your growth efforts?” Often, the response is vaguely, “Working Capital,” which raises concerns from an underwriting perspective. Such answers suggest that applicants may not fully understand their business’s capital needs, how to make the most of leverage/debt, or may not be disclosing the full story. Ideally, we want to hear responses like, “The funds will be used to achieve X” or “The capital will generate $X.”

In any successful transaction, both the financier and borrower benefit when a positive outcome is achieved. In other words, the working capital provided should create a constructive impact. Revenue-based financiers are genuinely invested in their client’s success, not only because they want to be paid back, but they want to keep deploying working capital to entrepreneurs with a productive cash generation cycle.

Understanding the Working Capital Cycle

The Working Capital Cycle (WCC) refers to the time it takes for a business to convert its net current assets and liabilities into cash. It encompasses several key stages:

• Purchasing Inventory: The cycle begins when a business acquires inventory or raw materials, typically on credit, delaying cash outflow.

• Production and Sales: After acquiring inventory, the business either uses it for production or sells it directly. Sales may be on credit, resulting in accounts receivable.

• Collection of Receivables: Finally, cash is collected from customers, completing the cycle.

The formula for calculating the working capital cycle is:

Inventory Days + Accounts Receivable Days – Accounts Payable Days = Working Capital

A shorter working capital cycle indicates efficient cash flow management, reducing reliance on external financing and enhancing liquidity[1][3].

Revenue-Based Financing: An Overview

Revenue-based Financing (RBF) is an alternative funding model where lenders provide capital in exchange for a percentage of future revenues. While this approach allows companies to avoid equity dilution and collateral requirements, it has limitations:

• Dependence on Revenue: RBF is suitable only for businesses that generate consistent revenues. Companies with fluctuating sales may struggle to meet repayment obligations.

• Higher Costs Over Time: The repayment structure often results in a higher total cost than traditional debt financing because repayments are tied to revenue multiples rather than fixed interest rates[2][4].

• Limited Applicability: RBF works best for specific sectors, like SaaS companies, which may not be representative of all small businesses seeking funding.

Why the Working Capital Cycle is Superior in Credit Decisions

1. Holistic Financial Health Assessment: The WCC provides a comprehensive view of a company’s operational efficiency and liquidity. By analyzing inventory management and receivables collection practices, lenders can better gauge a business’s ability to meet its short-term obligations.

2. Cash Flow Forecasting: Understanding the working capital cycle allows lenders to predict cash flow requirements more accurately. A company with a long cycle may need additional financing to bridge gaps between cash outflows and inflows, while one with a shorter cycle may require less support.

3. Risk Mitigation: Relying solely on revenue-based financing can expose lenders to higher risks if a business’s revenue declines unexpectedly. The working capital cycle offers insights into operational stability and risk management strategies that can inform lending decisions.

4. Encourages Operational Improvements: By focusing on the WCC, lenders can encourage borrowers to optimize their cash flow management practices—such as improving inventory turnover and speeding up receivables collection—ultimately leading to healthier businesses.

5. Flexibility Across Industries: Unlike revenue-based financing, which is often limited to specific sectors, the working capital cycle applies universally across various industries. This broad applicability makes it a more versatile tool for assessing potential borrowers.

Conclusion

In conclusion, revenue-based financing offers an innovative approach to raising working capital (i.e. without equity dilution or collateral). When applying for revenue-based funding, borrowers can woo lenders and secure larger amounts (at a lower cost!) with a deeper understanding of their working capital cycle. The WCC serves as a superior metric for lending decisions by offering insights into liquidity management and operational efficiency, ultimately leading to more informed credit decision and effective lender/borrower relationships.

Looking for alternative financing for your business? Apply now or contact us today!