Working capital loan definition
/What is a Working Capital Loan?
A working capital loan is intended to finance the day-to-day operations of a business, paying for such short-term investments as accounts receivable and inventory. These loans typically have a short life, with repayment required within a few months. They are most commonly used by businesses that experience highly seasonal sales, where the activity level spikes over a few months. They use the money to rapidly expand operations during the peak season. Once inventory has been sold off and the related receivables collected, the borrower has sufficient cash to pay back the loan.
Types of Working Capital Loans
There are several types of working capital loans available, with each one designed for different circumstances. The variations on this concept are described below.
Line of Credit
The most common approach to a working capital loan is the line of credit, which is an agreement between a lender and a borrower to issue cash to the borrower as needed, not to exceed a certain predetermined amount. It is usually supported by collateral and perhaps an owner’s personal guarantee. Most established businesses have a line of credit with their primary bank.
Accounts Receivable Financing
Another option for a working capital loan is accounts receivable financing, where short-term loans are matched with the borrower’s unpaid invoices, which are used as collateral. A business might also sell its accounts receivable to a lender, which pays it a discounted amount and keeps the entire amount paid by customers. Receivable financing is expensive, and so is more commonly used by smaller businesses that cannot obtain less-expensive debt alternatives.
Business Credit Cards
Yet another way to obtain a working capital loan is via business credit cards, which can be used for immediate purchasing needs, but which also have high interest rates associated with them. If it is not possible to pay off the balance on a business credit card at the end of each month, then an interest charge will be applied, so using these cards for longer-term financing is not recommended.
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When to Use a Working Capital Loan
It makes sense to obtain a working capital loan when a business experiences short-term spikes and drops in its operational activities, as is the case with seasonal sales. For example, a landscaping operation will experience a spike in its business during the spring, summer, and fall months, but will then have minimal sales in the winter. It might need a working capital loan to help pay for its staffing needs during the busy months of the year. As another example, a manufacturer of snow shovels might start building inventory months before the winter selling season, and needs financing for the increased amount of inventory that it will have on hand during the months prior to the start of the season.
There are also times when it does not make sense to take on a working capital loan. For example, when a business wants to acquire production equipment that it plans to use for the next 10 years, then a better choice would be to finance it with a lease or a long-term loan.
How Risky Are Working Capital Loans?
A significant risk for the lender is that poor sales during the peak selling season could result in the borrower not generating enough cash to pay off the loan. Consequently, working capital loans have a higher interest rate than more traditional long-term loans, and usually require some form of collateral or a personal guarantee by the business owner.
Pros and Cons of Working Capital Loans
There are several advantages to taking on a working capital loan. First, it can be obtained relatively quickly, which allows a business to meet a sudden cash need. In short, this type of loan can keep an organization in business when it cannot obtain funding from more traditional sources. Another benefit is that it can provide sufficient cash for a business to keep growing, when its growth might otherwise have been constrained by cash problems. A third benefit is that avoids the need to obtain equity financing; this is importantly in a closely-held business, where the current owners want to avoid bringing in additional investors and potentially losing control of the business.
There are also some disadvantages to working capital loans. One is that the owners of smaller businesses will be required to personally guarantee the debt. If the company defaults on the loan, then the lender can pursue the owner’s personal assets instead. Also, the interest rate on these loans can be high, making them too expensive for businesses with low profit margins. If a low-margin business were to take on a working capital loan, the associated interest cost might cause it to start reporting losses.
How to Apply for a Working Capital Loan
To improve the odds of obtaining a working capital loan, there are a few activities to complete prior to contacting a lender. First, construct a cash forecast to determine when cash will be needed, and in what amounts. The forecast should be based on a conservative view of the firm’s ability to pay back the debt within the terms that are likely to be set by the lender.
The next step is to obtain credit reports for both the company and its owners (on the assumption that they will be required to provide personal guarantees). If these scores are relatively low, then it will be difficult to obtain any type of financing. The odds of success may be improved by convincing someone with a high credit score to guarantee the debt.
The next step is to research available lenders, looking at their lending minimums, collateral and personal guarantee requirements, repayment terms, and interest rates offered. It is also worthwhile to read the reviews posted by borrowers about these lenders, to see if any are excessively difficult to work with. It is likely that some lenders are only interested in working with certain types of borrowers, and will say so on their websites. This analysis will reduce the set of available lenders.
After contacting the preferred lenders, be prepared to provide them with financial statements (perhaps audited). Personal financial statements will also be needed if the lender insists on a personal guarantee. The lender will likely also want to see tax returns for the past two years, as well as a business plan and budget. A formal loan application will need to accompany this information. An in-person interview may also be required.