Working Capital Loan
A form of debt financing meant to cover short-term financial needs
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What is a Working Capital Loan?
A working capital loan is a type of short-term loan offered by a bank or alternative lender to finance a company’s everyday operations. The goal of working capital loans is to provide working capital for short-term capital expenditures, such as wages, rent, debt service payments, or to finance activities, such as sales and marketing or research and development.
Summary
- Working capital loans are a form of debt financing meant to cover short-term financial needs, such as capital expenditures.
- A working capital loan can be an effective way to remain agile as an organization and respond to unforeseen opportunities by securing additional financing.
- Cyclical or seasonal business models can be boosted by working capital loans, with the loan financing immediate operational expenses during low-revenue periods.
What is Working Capital?
Before understanding working capital loans, we must first understand working capital. Working capital, at its core, can be thought of as money on hand. If an organization’s assets outweigh its liabilities, that organization has working capital.
Mobilizing working capital, however, can be more complex than simply having assets on hand, due to the relative illiquidity of some assets, such as land, or intangible assets, such as intellectual property.
How are Working Capital Loans Used?
A working capital loan seeks to supplement temporary shortfalls in working capital with outside funding. Working capital loans can be used for a variety of purposes, including tactical positioning of the organization.
For example, a sharp increase in demand for a company’s product due to unforeseen circumstances may present a unique opportunity for the organization. If the company does not have enough working capital on hand, and the demand for their product clearly outstrips its current production, it may seek funding to purchase additional raw materials to boost its inventory.
Similarly, a working capital loan may be sought by a business owner to take advantage of any discounts on large purchases being offered by a supplier. Such an investment in a resource that the organization will need may prove critical to the health of the business and its profit margins.
It should be noted that working capital loans are generally not used for long-term assets and investments, as there are forms of financing that offer better interest rates for such a form of investment.
Working capital loans can be either secured or unsecured, although most are secured or backed by collateral. In order to obtain an unsecured working capital loan, the organization will require a high credit rating to ensure the lender some insurance that they will be repaid.
Real-World Example
Often, working capital loans are used to help companies bridge financial gaps, such as the time delay between the collection of accounts receivable and the need to repay debt or accounts payable.
The need to bridge financial gaps is often seen in businesses that are seasonal or cyclical. Due to periods of high cash inflows followed by periods of relatively insignificant cash inflows, the organizations seek out working capital loans to remain operational during periods of reduced business activity.
An example in the real world is an organization that specializes in the manufacturing of Halloween masks. As the demand for such masks would be significantly higher in the fall, they would need to ramp up production activity in the summer, or even earlier.
However, because they may not be selling a lot of masks during the rest of the year, the working capital to mobilize production may simply not be available from their revenues and regular business operations. As such, they will seek out a working capital loan to begin production in the summer, and by the time their peak season hits, they will have the cash on hand to repay the working capital loan.
Benefits of Working Capital Loans
- Working capital loans are generally fast and easy to secure, allowing business owners to efficiently address any immediate financial needs.
- They are received all at once in a lump sum, increasing the impact of the funding.
- Business owners are not required to give up equity and control in their organization.
- Lending institutions can match the working capital loan payments to the cash flows of the business, not adding additional pressure on the business during low-activity periods.
Drawbacks of Working Capital Loans
- Interest rates are comparatively high to other forms of debt financing, to compensate the lender’s higher risk.
- For small businesses with no track record of cash flows, a working capital loan can be tied to a business owner’s personal credit, and any missed payment or default would hurt the individual’s credit score.
- The higher interest can be prohibitive to funding large-scale organizational efforts.
More Resources
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
