Working Capital Loans vs Working Capital Financing
Businesses of all sizes require financial assistance from time to time to help maintain their cash flow in both challenging seasons and during unprecedented growth spurts. A variety of industries — from construction to retail stores — can all benefit from working capital financing. Whether companies need to cover payroll costs, hire and train new staff, or pay monthly rent and operational expenditures, financing can come in handy.
In this article, we’ll cover the two major types of financing: working capital loans and working capital financing, and discuss the major differences, benefits, and drawbacks of each. It’s estimated that nearly one-third of all small businesses fail due to running out of capital, which is why it’s more important than ever to familiarize yourself with the various options available to you to help keep your business growth and success at the forefront.
What Is Working Capital Financing?
Working capital financing provides fast funds over short terms to cover necessary expenses like payroll and inventory. It entails different types of financing and may be more fitting for urgent expenses, rather than long-term investments. The type of financing that best aligns with your company will depend on a variety of factors, such as your company’s current assets, business model, the age of your company, and more.
Working capital financing is great for businesses that may experience short-term cash flow gaps. This way, financing can help sustain your business as it continues to grow.
What Is a Working Capital Loan?
A working capital loan is used to finance short-term expenses like debt payments and payroll. These types of loans are not meant to purchase long-term investments or equipment leases. Instead, it’s used for everyday operational expenditures to prevent any financial hiccups.
Certain sectors like the construction industry that have more cyclical demand may benefit from a working capital loan to help supplement their expenses during economic downturns. Likewise, businesses with more seasonal models with designated busy and slow seasons may also greatly benefit from a working capital loan when they experience periods of lower profit.
It’s important to keep in mind that these types of loans are connected to the business owner’s credit and that any missed payments or defaults can hurt your credit score.
Benefits of Working Capital Financing
Working capital financing has a host of benefits, including:
- Speedy Approvals: Many companies need a fast infusion of cash to support their staff and cover day-to-day operations. Many banks understand the need to quickly transport funds to your bank account so you don’t miss a step.
- Flexible Repayment Options: Repayment options are often customized to meet the needs of your business model. This is especially helpful for seasonal companies that require financial cushioning during certain times of the year. Working capital financing also provides a safety net in case of an inventory emergency.
- Cover Expenditure Gaps: Working capital financing doesn’t require business owners to give up any equity, which is especially important for businesses that are just starting out. Instead, this type of financing can help cover expenditure gaps so businesses don’t have to worry about meeting their daily working capital needs.
- Positive Impact on the Turnover Ratio: When a business is just starting out, every dollar matters. Working capital turnover is a measurement of how much profit (sales) is created with every dollar of working capital. This measurement can also tell business owners how much working capital financing they need to stay afloat in the years to come. Businesses that are unable to meet their repayments, should not opt for working capital financing, as it can lower their credit rating.
What Are Some Considerations About Working Capital Financing?
Before pursuing working capital financing, it’s important to understand it in its totality to decide if it’s right for you.
- Expensive: Certain types of working capital financing can be expensive, including merchant cash advances.
- Not for Pre-Revenue Companies: Companies without a proven track record and consistent stream of revenue may not be eligible for working capital financing.
- Lender or Finance Company Requirements: Borrowers may need to adjust their own debt collection processes, billing, and credit to meet the lender’s or financial institution’s practices.
Advantages of Working Capital Loans
Discover some of the advantages of working capital loans include:
- No Collateral Required: Working capital loans include options that don’t require any collateral. As the borrower, you get to retain 100% ownership over your businesses without putting your house, car, or company on the line.
- Better Cash Flow: Whether you run into an inventory shortage or a different problem, working capital loans can provide a financial buffer between you and financial hardship. A working capital loan allows you to compensate for monetary loss while hiring new staff quickly and keeping the lights on.
- Spending Flexibility: There are very few limitations on how you spend your money with working capital loans. You’ll retain control over how best to spend and allocate the money.
- Processed Quickly: When you need money in a pinch, working capital loans are a great avenue to pursue as the funds are generally processed to your account fast.
Are There Drawbacks to Working Capital Loans?
Take time to review any possible drawbacks to pursuing working capital loans. Consider the following:
- Possible High-Interest Repayment: When taking out a working capital loan, you must also account for the interest payments. Larger loans may have a higher interest rate while smaller ones may have a lower interest rate. Most working capital loans are expected to be paid back in a shorter time frame since they are not intended to solve long-term cash flow problems.
- Credit Impact: If you’re unable to make payments on time, your credit score may be negatively affected. It’s important to ensure that you have a consistent revenue stream before taking out a working capital loan so you have the peace of mind to be able to make repayments on time. The loans are tied to the business owner’s personal credit score, which can complicate approval processes in the future if you cannot pass a credit check for your next financing move.
- Short-Term Solution: The purpose of working capital loans is to provide a temporary financial buffer, not a long-term financing solution. They are not intended to be your sole financing method. Make sure your business can survive even after you use up your line of credit.
What Are the Different Types of Working Capital Finance?
Discover the different types of working capital finance options:
- Working Capital Loan: A working capital loan covers the daily costs of running a business. This could include operational costs, such as rent. If you know you will generate enough funds to pay for the cost of the loan (plus interest) then this may be a great option for you.
- This type of loan is generally viewed as a short-term financial solution, rather than a long-term financing crutch to sustain your business. It can provide temporary financial relief for short-term projects, but as you need to reapply for it time and time again, it is not ideal for ongoing cash flow shortages. Loan sizes can range anywhere from a few thousand dollars up to millions.
- Line of Credit: Business owners can borrow up to a certain amount with a line of credit from a lending institution. This is one of the most flexible, long-term options available.
- Hypothetically speaking, a company could take out a line of credit for the year as they expand into new territories and require this line of credit for ongoing construction projects. The company would repay a percentage of its debt monthly. If the company runs into setbacks as the months go on, it could then take out a higher amount on its line of credit.
- This option typically has lower interest rates compared to bank loans and is available when the company requires additional financing at a moment’s notice. The lower interest rates are because interest only grows when debt is borrowed from the line of credit.
- Overdraft: Overdrafts can be issued by lending facilities or the financial institution in charge of your corporate bank account. Similar to overdraft protection on a simple checking and savings account, an overdraft covers any charges when your balance falls below zero up to a certain amount. This ensures that your payments go through and vital checks don’t bounce.
- Overdrafts function similarly to a line of credit but are non-revolving, which means once all of the credit is paid off, the lender closes your account. For this reason, they tend to be tied to the business owner’s individual bank account, rather than the business’ bank account.
- Invoice Discounting: An invoice discounting transaction involves a company selling its account receivables to a third party. This is a great option for small to medium-sized businesses, as it’s a more hassle-free process compared to other avenues. The invoice discounting is backed by the company’s invoice, which is considered an asset. An invoice is a list of transactions that details the services rendered or products sold to the customer, as well as the total amount due.
- Revenue-Based Financing: Revenue-based financing is an agreement between the business owner and the lender that exchanges working capital for a percentage of a business’s future revenue stream. This amount is typically paid back in daily or weekly installments until the total amount is recouped.
- Business owners do not need to sign away equity or meet extensive eligibility requirements that most traditional lenders require. Those with a minimal credit check score are not disqualified from revenue-based funding.
- The quick infusion of cash can be used to increase inventory, remodel, expand marketing efforts, and purchase new technology or equipment. Revenue-based financing provides financial cushioning for companies with razor-thin margins or cyclical business models.
What Types of Working Capital Loans Are There?
There are multiple types of working capital loans you can take advantage of. Keep reading to find the one that is right for you.
- Short-term Loans: Short-term loans provide quick financial relief and typically have a fixed interest rate and repayment period in place. They can be great options if you have a good credit score and require cash fast.
- Bank Overdraft: Banks provide overdraft protection for business accounts. If a company needs to pay for materials and comes up short, a bank will contact their customer and provide overdraft protection so their check doesn’t bounce. This also includes fixed interest rates.
- Accounts Receivable (AR) Loans: AR loans are helpful for business owners that need to quickly fulfill purchase orders, but lack the capital to do so. Lenders require that business owners sign a promissory note guaranteeing that they will repay the loan (plus interest) once the orders have been fulfilled.
Where to Apply for Either a Working Capital Loan or Working Capital Financing?
In need of cash fast? At Mantis Funding, we provide revenue-based financing for a variety of industries. We offer funding up to $500,000 and flexible repayment plans. Contact us today to get started!