Working Capital Loan

It is a short-term loan mostly offered to highly-cyclical or seasonal businesses during periods of low revenue

A working capital loan is a short-term loan mostly offered to highly-cyclical or seasonal businesses during periods of low revenue.

Working Capital Loan

Another practical use of this type of loan is to respond to unexpected opportunities by getting additional funding, which can make the company more flexible.

Missed payments or defaults may decrease a company owner's credit score since these loans can be tied to the owner.

What is working capital?

The gap between a company's current assets and current liabilities is known as working capital. It signifies whether a business has adequate liquid assets to maintain its operations.

Computation

A company with more current assets can use the excess amount to pay bills. But, on the flip side, the company might have to take out working capital loans to continue operating. 

  • What are current assets? These are a company's assets that can be converted into cash within a year. These can be cash, cash equivalents, inventory, accounts receivable, etc.

  • What are current liabilities? These are the debts that a company owes and is expected to pay within a year. These can be loans, accounts payable, etc.

Working capital formula = current assets - current liabilities

= existing assets - cash - current liabilities ( this alteration excludes cash )

= accounts receivable + inventory - accounts payable (this alteration works with the working capital that deals with the day-to-day operations of the business)

Understanding working capital loans

Working capital is most often used in times of unforeseen opportunities. During these times, the company might be short on money but need funding to meet production goals, expand the business, etc.

Bulb

For instance, a company produces merchandise. During Christmas, there is a sharp increase in the demand for holiday-themed clothing.

If the company doesn't have enough funding to meet the demand, it may take out a loan to purchase additional materials and labor. 

This type of loan can be used to purchase a more significant amount from the supplier to take advantage of any discounts. 

However, this is not always a good sign since this type of loan is not for investments or the purchase of long-term assets. Therefore, this might indicate that the company is having problems retaining liquid assets

Working capital loans are usually backed by collateral but can also be unsecured. However, the lender must have a high credit rating to obtain an unsecured loan.

Pros and cons of working capital loans

The pros and cons are:

Pros 

  • Working capital loans are typically quick and straightforward, enabling business owners to take care of urgent financial demands swiftly.
  • The impact of the financing is increased because it is received all at once, in one lump payment.
  • Owners of businesses are not obligated to cede ownership and management of their company.
  • Lending institutions can align the working capital loan repayments with the company's cash flows, reducing operational stress during slow periods.

Coins

Cons 

  • To offset the lender's more significant risk, interest rates are higher than other debt financings.
  • A working capital loan for small firms without a history of cash flows may be based on the business owner's personal credit, and any missing payments or default would lower that person's credit rating.
  • Large-scale organizational activities may be impossible to finance due to the increased interest rate.
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Researched and authored by Huy Phan | Linkedin

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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