Cash Flow Solutions

Understanding Working Capital Loans

Understanding working capital loans

Working capital loans are a great way for businesses like yours to generate capital and to start becoming laser-focused on business growth.

A working capital loan is a specialized loan type that is granted to businesses and designed to meet the everyday financial needs of running a business. With working capital loans, your small business isn’t required to submit the loan’s purpose to the lender during the application process. Typically working capital loans aren’t used to purchase assets or for long-term financing. They’re used for short-term business financing needs.

Types of working capital loans

Working capital can come in various forms. Here are some to consider:

  • Bank credit line
  • Short-term loans
  • Funding via personal resourced (HELOC, P2P or family loans)
  • Factoring or accounts receivable financing
  • Trade credit
  • Equipment loan or lease financing

No matter the type, working capital is calculated by subtracting your current liabilities you’re your current assets.

Current Assets – Current Liabilities = Working Capital

The advantages of working capital loans

  • You are prepared to handle any financial difficulties that may arise.

Under the best of circumstances, poor working capital leads to financial pressure on a company, increased borrowing and late payments to the creditor – all of which result in a lower credit rating. A lower credit rating means banks charge a higher interest rate for any money borrowed. Applying for and using a working capital loan when you need it most will keep you in business when shortages occur.

  • You can and will maintain ownership of your company.

If you were to receive funding from an equity investor, you would likely have to give up a generous percentage of your company in return. In turn, you are giving up a portion of your decision-making ability as well. But, if you borrow funds from the bank or another financial institution, you are obligated to make the agreed-upon payments on time. But that’s the end of your obligation to the lender. You can choose to run your business however you choose without outside interference.

  • There’s no collateral required.

Working capital loans come in both secured and unsecured forms, although many are unsecured. Unsecured working capital loans are given only to those small businesses that have a very good credit history and/or have little or no risk of default. If you’re lucky enough to qualify for an unsecured loan, you won’t need to put up your business, inventory or anything else to secure the loan.

  • They offer shorter terms for short-term problems.

Working capital loans are designed to help with infusing money into your business for the short term: a hiccup here, a blip there and a needed cash injection too. You won’t have to plan for years of monthly payments to pay back what you borrowed.

  • You can use the money however you see fit.

Banks and lenders have few if any restrictions on how you use the money. They just want you to use the money to maintain your operations or to do things that will increase your opportunities for revenue. That works out well because as a smart business owner, that is exactly what you want to do with it too.

  • They can be quick.

Applying for a typical business or personal loan can take up a lot of your valuable time and may not even end in approval. What’s the point of going through excessive paperwork, a lengthy approval process, putting up collateral, personally guaranteeing the loan, making fixed monthly payments and having restrictions on how you use the money if your request is just going to get denied? Working capital loans allow borrowers to access money almost immediately, usually within a week after the application is accepted.

The disadvantages of working capital loans

  • You need to consider repayment.

Yes, you actually have to repay the loan. This is usually a given when you borrow money. As with any type of loan, your sole obligation to the lender is to make your payments. Unfortunately, even if your business fails, you’ll still have to make these payments. And if you are forced into bankruptcy, your lenders will have a claim to repayment before any equity investors.

  • Some collateral may be required.

Some working capital loans will require some degree of security for the lender. The guarantee may be something like a factory, home, inventory or even jewelry. These items can also be given as a guarantee even if there are existing mortgages on them.

  • There are higher interest rates.

As many working capital loans are unsecured, they usually include higher interest rates than secured business loans. This means your business will pay more over the life of the loan than it would have paid for a secured loan of the same amount. Unsecured business loans are also harder to qualify for. If your business has a poor or nonexistent credit history, the lender may not approve your application.

  • There are potential impacts on your credit rating.

It might seem like a good idea to keep taking out loans when your small business needs money, but each loan will be noted on your credit rating. And the more you borrow, the higher the risk to the lender, and the higher interest rate you’ll pay. Also, slow payment and no payment will be direct hits to your credit rating, so be sure you will be able to pay back any money you borrow.

  • There are short terms.

Yes, this is both a benefit and a disadvantage based on your business needs. A major disadvantage of getting funds from this type of loan is the fact that the funding is only intended for short-term solutions. These loans will not suffice for long-term business goals or comprehensive business projects that will need higher investments with longer repayment terms.

Want to dig deeper?