A Primer on
Working Capital Financing
Find out all the available financing options to grow your business.
Updated November 1, 2020
A working capital loan is a financing option that is used for covering the everyday expenses of a company. To that end, this type of financing is not typically use for big, one-time purchases. Instead, it is used for paying wages, accounts payable, and the list may go on. Companies that find working capital financing especially useful are those that are highly seasonal or those with cyclical sales whose revenue fluctuates.
This kind of financing is geared to short-term financial needs, meant to ensure that a firm carries out its daily operations. In general, the loan is repaid by the company when it enters the busy season and it no longer depends on the financing to work accordingly.
Types of working capital financing loans for your business
A good credit score, the interest rate and the maximum line of credit that you can get depends on your company’s relationship with the lender. One advantage that this type of credit facility has over other types of working capital loans is that the borrower only pays for the interest applicable to the amount that has been overdrawn. The rates are typically set between 1 and 2 percent above the prime rate of the bank.
These are the most usable forms of working capital financing that are mainly used by both small and large businesses. These cash facilities are provided by the commercial banks by which the borrower is approved a specific amount of cash that he can use for making business payments. Additionally in this setting, the borrower has to make certain that he does not cross the approved limit. The good thing is that the rate of interest is charged to the level the cash is used and not at the approved amount which encourages him to keep depositing the amount when possible to save on interest rate.
Truly, this is valuable working capital financing.
Cash credit or bank overdraft is the most useful and appropriate type of working capital financing extensively used by all small and big businesses. It is a facility offered by commercial banks whereby the borrower is sanctioned a particular amount which can be utilized for making his business payments. The borrower has to make sure that he does not cross the sanctioned limit. The best part is that the interest is charged to the extent the money is used and not on the sanctioned amount which motivates him to keep depositing the amount as soon as possible to save on interest cost. Without a doubt, this is a cost-effective working capital financing.
Unlike a line of credit, a short term loan comes with a fixed interest rate and payment period. The loan repayment period is typically 12 months. Among all types of working capital loans, this particular credit facility is usually secured. However, if your business has a good working relationship with the lender and you have a good credit history, you may be able to get a short-term debt, even without any collateral.
Short-term loans (also sometimes called cash flow loans) are issued to borrowers in one lump sum and are paid back in regular fixed installments over a short amount of time. Unlike installment loans, short-term loans have fixed fees instead of interest charges.
Short-term business loans for working capital a great option because most working capital business needs are short-term. (You won’t be spending years paying back a loan.) Generally, short-term working capital loans are also easier to qualify for than medium- or long-term loans, making them a good option for young businesses.
This particular loan type is commonly obtained from personal resources, such as investment from friends or family and home equity loans. This kind of working capital loan is the most ideal for businesses that are just starting up. Also, equity loans may be the most practical loan facility that you can get in case your company does not have a good credit history.
Another way to secure working capital is by applying for loans that take into consideration the accounts receivable, or confirmed sales order value of your company. This type of debt is ideal if your company lacks funds to fulfill a sales contract or order. However, lenders usually provide this type of working capital loans only to businesses that are reputable or those that have a proven track record for paying debts and fulfilling obligations.
This type of working capital debt is very similar to the accounts receivable loan. The only difference is that instead of confirmed orders or accounts receivable, the value of the loan is based on future credit card receipts. This particular debt is only appropriate for businesses that accept credit card payments.
Invoice factoring is an arrangement in which a business sells all or some of the accounts payables to a third party at a value lower than the original value of those accounts. The third party in this setting is called the factor that offers factoring services to business. The factor provides financing by purchasing the bills and additionally collects the amount from the debtors.
Invoice factoring is a fast working capital solution for businesses with B2B or B2G invoices in need of financing from $5,000 to $20 million. Unlike accounts receivable financing, to get a larger funding amount you’ll typically need to assign your invoices to your provider and give them some customer control.
A loan that is provided by a present or potential supplier is called a trade creditor working capital loan. More often than not, suppliers will offer a trade credit facility if you place bulk orders from them. However, before you can secure such a loan, you can expect that the trade creditor will thoroughly check on your company’s credit history.
This is a type of working capital financing that is extended by the present or potential supplier of a business. Trade credit is offered to businesses based on their creditworthiness, which is revealed by its profit records, liquidity situation and payment records. As other funding programs, trade credit also comes with some specific requirements and costs. The supplier will also thoroughly evaluate your business credit history before offering you money.
This is simply the credit period which is extended by the creditor of the business. Trade credit is extended based on the creditworthiness of the firm which is reflected by its earning records, liquidity position, and records of payment. Just like other sources of working capital financing, trade credit also comes with a cost after the free credit period. Normally, it is a costly source as a means of financing business working capital.
The last one source of financing is “Factoring”. In this source of funding the business sell all of its or selected account receivable to the third party on discount or at lower price. The party who are providing factoring services is called Factor. The Factor is third party organization whose responsibility would not only to provide the services of financing through selling the account receivable but also to collect the amount from the debtor as well.
There are two types of factoring:
Factoring with recourse: if the credit risk of non-payment by the debtor is because of business it would be factoring with recourse.
Factoring without recourse: if the credit risk of non-payment by the factor then it would be considered as without recourse.
For a small business, it is another good type of working capital financing provided by the commercial banks. Every business generates bills in their normal routine while selling products or services to debtors. In the end, that bill works as a document to get payment from the debtor. And if the seller needs cash, he will go directly to the bank with that bill and the bank will apply discount on the whole amount of the bill primarily based on the existing interest and pay the outstanding amount to the seller. The bank will collect the money on the maturity date of that bill.
Another alternative to a working capital loan is a business credit card. A business credit card is a good option for businesses that are very small (micro businesses), want to manage employee expenses, or earn rewards. It can also be a good option as a startup business loan with no collateral.
The Small Business Administration (SBA) is a government organization that assists businesses in part via a number of loan programs. The most popular is the 7(a) loan, which can be used for many business purposes, including working capital. The SBA guarantees a portion of your loan, so if you don’t have the collateral necessary to get a low-cost loan on your own, a 7(a) loan is a very good option.
Because SBA loans are government-backed, they can be much more difficult to qualify for and the application process is lengthy. Nonetheless, eligible businesses may qualify for a loan with low rates and long-term lengths.
The SBA Export Working Capital Loan (EWCL) program is for U.S. small businesses that are able to generate export sales, to help them increase these sales. The SBA says their aim for this program is "to ensure that qualified small business exporters do not lose viable export sales due to a lack of working capital." Here are some details about the EWCL program:
The SBA provides a 90 percent guarantee on these export loans.
The loans are for manufacturers, wholesalers, export trading companies and service exporters that have been in existence for one year (although the one-year requirement can be waived if the business can show expertise).
Collateral for these loans is the inventory and the receivable generated by the sale. The SBA also requires the personal guarantee of owners [20 percent or more ownership).
The maximum EWCP line of credit/loan amount is $2 million.
The basic SBA 7(a) loan program includes working capital loans.
Small Business Administration (SBA) loans are a popular choice for businesses that need working capital for two reasons. First, the borrowing limits are high. The SBA’s 7(a) loan program, for example, allows eligible businesses to borrow up to $5 million. Most online lenders limit borrowers to $500,000 or less.
Second, SBA loans offer some of the lowest interest rates you’ll find for a working capital loan. SBA SmartBiz loans, for instance, feature rates of 6.25% to 7.25%. If paying the least amount of interest is a priority, this type of loan may be more appealing than the other working capital options mentioned earlier.
There is a slight hitch, however. It can take weeks or even months to get an SBA loan funded. When time is of the essence, choosing one of the alternatives is likely to going to make more sense for your business.
This is a non-fund based working capital financing. Bank guarantee is acquired by the client or seller to decrease the risk of loss to the other party due to non- performance of agreed undertaking which may be paying back the money or offering some services and so on. A bank guarantee is repealed by the holder only in case of non-performance by other party. Bank will charge some commission and may also ask for some security.
This is the non-fund based working capital source of financing. In such sources of financing the Buyer or seller approaches to the bank and acquire bank guarantee in order to reduce the risk / uncertainity or reducing the risk of loss from the opposite party which may be in the form of repaying money or some services. In case of non performance of the agreement Banks revoke the agreement.
This form is also known as non-fund based working capital financing. There is a little difference between letter of credit and bank guarantee. So, a buyer would purchase a letter of credit and send it to the seller. As soon as the seller sends the products according to the agreement, the bank would pay the amount to the seller and collects that cash from the buyer.
This is also non-fund based WC source of financing. There is very little difference in between LC and Bank Guarantee. In case of Bank Guarantee on nonperformance of the agreement Banks revoke the agreement. But in case of Letter of Credit the buyer purchased the LC from the bank and send it to the seller and received the good as per agreement. The banks will pay the amount to the seller on behalf of buyer to the seller and collect then collect this amount from the buyer.
With a line of credit, you are given access to a certain amount of money. You can draw from this line of credit at any time, up to your maximum credit line amount. Often, lines of credit are revolving, meaning as you pay off your debts, you can draw from the funds again.
A working capital line of credit can be a great way to achieve more consistent cash flow. These loans are also helpful for businesses that don’t know how much they need to borrow or that want a cash cushion for unanticipated expenses. In addition, revolving lines of credit ensure that your business has quick access to funds without the need to apply for an additional loan.
In the simplest terms, a merchant cash advance involves borrowing against your business’s future debit and credit card receipts. The lender provides you with a lump sum of working capital and you hold back a percentage of your daily debit and credit sales for repayment.
Merchant cash advances can put working capital in your hands quickly. Typically, it’s possible to borrow anywhere from 50% to 250% of your business’s credit card transactions. There is a downside, however. The annual percentage rate (APR) can easily climb well into the double-digit range, making this a potentially expensive choice for working capital.
Merchant cash advance lenders use a factor rate to determine the cost of borrowing. This rate can range from 1.15 to 1.5 and the higher the rate, the more expensive the loan. Here’s an example.
If you need an advance of $20,000 and you have a factor rate of 1.2, you’d repay $24,000 altogether. Assuming you have $20,000 in credit card sales each month and you commit 15% of daily sales to repaying the advance, it would take you 240 days to pay it off. The total financing cost would be $4,000 and the APR would work out to 57%.
Learn more about working capital financing
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