What Is Working Capital Financing?

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business woman using calculator

Last Updated on November 2, 2022

It’s not uncommon for companies to not have enough cash on hand for their daily operations. This is why 20% of new businesses fail during their first two years of opening, 45% during their first five years, and 65% during their first decade.

Whether you are finding it difficult to get new stock, buy new equipment, or pay your employees during slow months, working capital financing may be the answer to your problem.

Working capital financing can support your daily operations, fund your company expansion plans, or help your business remain strong during challenges. This financing option can improve many aspects of your business to meet your short-term obligations.

What Is Working Capital Financing?

Before you know what working capital financing is, you first need to know the definition of working capital. Working capital refers to the money you have on hand to pay your staff and your rent, as well as other operating expenses. In many ways, it involves all the funds you use to cover short-term financial obligations.

If you regularly monitor your cash flow statement, your working capital can be determined by subtracting your current liabilities from your assets. Ideally, your capital must be positive.

This means that your short-term debts and liabilities should be less than your current assets, especially your cash on hand or liquid assets. When you have positive working capital, you can fund your operations effectively.

Working capital financing is a loan you take to finance these operations. This type of loan should not be used to fund long-term investments or assets. Instead, it should be utilized for immediate needs such as rent, debt payments, and payroll.

Working capital financing is not uncommon. According to the World Bank, 28% of firms use banks to finance their working capital.

When taking out working capital financing, keep a detailed plan on how you want to use the money, including income projections of how the working capital will help your business to grow. If you fail to do this, you may find yourself buried in debt.

Types of Working Capital Financing

There are many types of working capital loans that can benefit your business. Each has its advantages and disadvantages. It is vital to compare different financing options to see which one suits your needs the best.

Type of Working Capital Financing Pros Cons
Short-term loan
  • Fast approval
  • Low paperwork requirements
  • High-interest rates
  • Can become reliant without exploring other options
Bank overdraft
  • Helps to maintain a good track record
  • Less paperwork
  • Risk of seizing
  • High-interest rates
Invoice factoring
  • Fast approval and funding
  • Does not impact credit
  • No additional collateral needed
  • Ownership of the business will be retained
  • Higher rates than traditional financing
  • Possible disruptions in client relationships
Equipment loans
  • No need for additional collateral
  • Great way to get new equipment
  • Restricted usage
  • High-interest rates
  • Can cause expenses to pile up when issues arise
Credit Line Loan
  • Lower risk
  • Variable interest rate
  • Hard credit valuation process
  • More expensive than other secured loan

Short-Term Loan

A short-term loan is a type of working capital financing that has a fixed payback period, which usually runs between six months to one year. It also has a fixed interest rate. One of the major advantages of short-term loans is that borrowers can easily and quickly get approved if they have a good credit score.

It also has minimal documentation and verification needed, as well as requires no collateral. This makes it a great type of loan for companies that need cash fast. However, some short-term loans, like merchant cash advance (MCA) loans, have high interest rates and aggressive renewal offers, which can result in a businesses becoming reliant on an expensive form of financing when there are better and more affordable options available.

Business Overdraft

A business overdraft is a type of working capital loan offered by banks to their customers. When a customer’s account does not have enough funds to cover their expenses, banks may allow overdraft to meet their financial needs. Doing so can help a business keep a good track record, and it typically does not require much paperwork to be approved for.

However, there are typically high and variable interest rates associated with bank overdrafts, making it difficult to predict costs in the long-term. Additionally, if the overdraft is secured against some sort of collateral and the business fails to make its payments, the bank could seize the company’s assets.

Invoice Factoring

Invoice factoring is another source of working capital financing in which a company sells its accounts receivables to a third party, or factoring company, at a discounted rate. The discount serves as the service charge for the entity taking on the owed invoices.

This type of working capital financing relies primarily on the creditworthiness of a business’s customers, rather than on the credit of the business itself. Because of this set up, invoice factoring can be easy and quick to get approval for if a business’s customers are reliable and creditworthy. Additionally, once a company has been approved to factor its invoices, it can often get same day funding.

The primary disadvantages associated with invoice factoring are its higher rates and the potential additional friction in the invoicing process. Because the factoring company steps in to work with the debtors, there can be some disruptions with client relationships.

Equipment loans

An equipment loan is very useful for businesses that need to purchase new machines, vehicles, or other equipment.

One excellent feature of this loan is that the equipment can serve as collateral. However, this type of financing tends to be pricier when it comes to interest fees as well as other charges.

It can also be restrictive since it will only cover the cost of the equipment, so you have to cover fees for maintenance and accessories separately.

Credit Line Loan

All businesses and entrepreneurs have a credit limit, and they can only take out financing options that fall within that limit. This type of financing is great for brands that need to take out low risk loans periodically from a bank or other institutions.

It is very beneficial, especially for entrepreneurs who rely on market forecasts and can predict certain periods of the year that involve greater operating costs.

However, the credit valuation process can be difficult, especially if a business does not get approved the full amount that it needs. And a credit line loan can be more expensive than other funding options, such as a secured loan.

Advantages and Disadvantages of Working Capital Loans

Working capital loans are easy to secure. Therefore, entrepreneurs can address any business crisis immediately. Because this type of financing is received in a lump sum, the impact is felt more.

Aside from that, business owners do not need to give up control of their business, and there is no additional pressure on low-sales periods.

On the flip side, the interest rates are higher to compensate for the high risk assumed by the lender. Businesses that do not have current records of their cash flow may also find it hard to secure loans, and if so, loans will be tied to the owner’s credit.

In addition, the high-interest rate can also be a hindrance for large-scale efforts that will take a long time to recuperate costs and see a profit.

How Do You Know If You Need Working Capital Financing?

No matter how well you handle your finances, you will still deal with controlling your cash flow and taking out financing options.

As with other loans, taking it out should be done with precaution in mind. If you’re still unsure, here are some situations that may require you to seek working capital financing.

When Business Is Slow or Inconsistent

If you run a seasonal business, the bulk of your orders will come during specific times of the year. During the other times of the year, you may need more money to keep your business afloat, and during your busy months, you may need extra staff to handle your extra orders.

Aside from seasonal businesses, economic slowdown scenarios can also impact your cash flow and may require you to seek working capital.

If your business works on a project basis, you need to plan for your finances accordingly. For instance, when you have a large project that pays only upon completion, you need working capital financing to keep your business going until the order has been paid.

Working capital financing may also be needed if your clients do not pay their bills on time and inventory turnover takes a long time. These factors can adversely impact your cash flow, so instead of liquidating your invoices, be proactive and simply take out working capital financing.

When You Experience Sales Spurts

It’s normal for startups and small businesses to struggle with making ends meet. Because of this, many businesses are unprepared for unexpected growth spurts. Thankfully, working capital financing can help cover expenses such as marketing, advertising, and payroll, among other things.

When New Opportunities Arise

Opportunities are a big deal, especially for small businesses since they do not knock twice. Do not pass up on good opportunities just because you don’t have enough money.

Instead, get capital financing to fund your expansion. This could cover employee training and new equipment.

When You Run Out of Emergency Cash

When your cash flow is interrupted, your business can suffer. Working capital financing can help you have emergency cash on hand that can be used to fix problems that arise.

Real-Life Example

By now, you already know that working capital financing is used by companies to fill in gaps. To help you understand its concept better, here’s an example.

Company A specializes in manufacturing Christmas ornaments. Since the demand for such items is significantly higher during December, they need to vamp up their production as early as October so they can meet the demand for the incoming Christmas season.

However, because they are not selling ornaments during the rest of the year, they need to apply for a working capital loan to jumpstart their production and pay additional workers. By the time the Christmas season hits, they will have cash on hand to repay the loan.

Key Takeaways

Working capital financing is extremely useful for many businesses. However, it should not be taken lightly. Instead, it should complement your operating cycles and cash flow management.

This financing option has been proven time and time again for small businesses. The good news is this type of loan is becoming easier to obtain without having to worry about approval delays and paperwork that involves a lot of your precious time.