Home / Glossary / What is a working capital funding gap?
A working capital funding gap, also known more simply as a funding gap, is the difference between a company’s short-term assets and its short-term liabilities. In other words, it represents the amount of money a business needs to cover its immediate financial obligations.
Working capital is calculated by subtracting current liabilities (like accounts payable and short-term obligations and debt) from current assets (such as cash, accounts receivable, and inventory). A funding gap emerges when current liabilities exceed current assets, leaving a net capital deficit.
Since working capital is the lifeblood of any organization, ensuring that day-to-day operations run smoothly, a working capital funding gap can be extremely problematic. It can not only limit a business’s ability to cover its obligations but also restrict it from capturing opportunities for growth.
More specifically, it can profoundly impact a business’s capacity to purchase inventory, maintain production levels, and invest in research and development. This, in turn, means that the affected business will struggle to grow and is at risk of falling into a dangerous downward spiral caused by a negative working capital position that means they can’t cover operating expenses.
While it’s normal for businesses to experience fluctuations in cash flow, which, by extension, can lead to working capital funding gaps, a proactive approach to working capital management can help businesses avoid them.
This involves investing in better cash flow forecasting capabilities, carefully monitoring cash flow into and out of the business, adopting a more sophisticated approach to supplier management and inventory management, and taking advantage of working capital financing techniques.
With the right approach, businesses can minimize their vulnerability to working capital funding gaps and ensure their operations can continue running as smoothly as possible.
What causes a funding gap?
Working capital funding gaps are fundamentally caused when short-term liabilities exceed short-term assets. But there are several particularly common situations which can lead to funding gaps if not addressed proactively, including:
- Mistimed cash inflows and outflows: When cash flow into and out of the business from accounts receivable and accounts payable are thrown out of balance, and outflows drastically exceed inflows, businesses can find themselves with a working capital funding gap.
- Rapid, underfunded business growth: Periods of significant business growth typically involve a lot of spending, but revenue generated might not match the pace of that spending. Without external funding, businesses are vulnerable to negative cash flow.
- Inefficient inventory management: Purchasing and holding excessive levels of stock or raw materials for production without the customer demand to match it can cause a funding gap. Equally, too little stock on hand can mean missing out on sales opportunities, which can damage cash flow.
- Seasonal business fluctuations: Certain types of businesses have demand that fluctuates throughout the year, causing down periods where revenue can drop while costs remain relatively flat, which can cause negative cash flow and a potential funding gap.
- Unforeseen external factors: Broad-based economic downturns, changes in market conditions, or unexpected events like natural disasters all pose risks to supply chains and customer demand, with the potential to impact revenue streams and amplify financial challenges.
Planning methods to address each of these potential funding gap causes, and any others that are specifically relevant to your business, is crucial in avoiding significant business issues in the event they occur.
How to close a working capital funding gap
Despite the risks that working capital funding gaps pose to businesses, plenty of methods can be used to avoid, mitigate, or close them.
By incorporating these strategies into their broader operational plan, businesses can ensure they’re protected from the worst threats that funding gaps present.
Strategic cash flow management
Strategic cash flow planning and management can help businesses minimize the chances that they’ll find themselves with a working capital funding gap in two main ways.
Firstly, better cash flow forecasting capabilities can help them to identify potential periods of financial risk that are approaching. This means they can plan to avoid or mitigate the negative ramifications of any projected downturns in revenue or upturns in costs.
They can then deploy cash flow management strategies, like decreasing inventory on hand, investing more in marketing, or seeking external financing to avoid operations being impacted.
Working capital financing
There are various forms of working capital financing, including supply chain finance and accounts receivable finance, which can help businesses to take more control over their working capital position.
Accessible through working capital finance solutions, these forms of financing allow businesses to increase the velocity of cash inflows due from their customers or slow down cash outflows to their suppliers.
They can then use the cash that’s freed up from their accounts receivable or accounts payable to build operational resilience, shore up their balance sheet, or invest in growth opportunities.
Optimized inventory management
The amount of inventory a business holds is a significant component of its total current assets, so a better-optimized approach to inventory management can significantly influence financial health.
There are two main considerations when tailoring an inventory management strategy to avoid the risk of working capital funding gaps: to avoid having too much or too little inventory on hand at any one time.
The former ensures that they are kept in check. The latter means that the business will always be able to meet demand and can, therefore, avoid missing out on revenue-generating opportunities.
An integrated approach to avoiding working capital funding gaps
Working capital funding gaps can spell disaster for a business if left unchecked, which makes it extremely important that your overall operational strategy accounts for the risk they pose.
Preventing a working capital funding gap from arising in the first place is far better than digging your way out of it when it occurs, so make sure you’re taking full advantage of the tools and techniques at your disposal to minimize the chances of your working capital position stays in line with your business goals.
That includes using dedicated solutions like accounts receivable financing, supply chain finance, and cash flow forecasting software to stay one step ahead.
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