What is a Working Capital Loan
A working capital loan is a loan that is taken to finance the everyday operations of a company. Working capital loans are not used to buy long-term assets or investments and are, instead, used to cover accounts payable, wages, etc. Companies that have high seasonality or cyclical sales cycles usually rely on working capital loans to help with periods of reduced business activity.
BREAKING DOWN Working Capital Loan
Working capital is the cash available to finance a company's short-term operational needs. However, sometimes a company does not have the adequate cash on hand or asset liquidity to cover daily operational expenses and, thus, will secure a loan for this purpose. Working capital loans are simply corporate debt borrowings that are used by a company to finance its daily operations.
Many companies do not have stable or predictable revenue throughout the year. Manufacturing companies, for example, have cyclical sales cycles that correspond with the needs of retailers. Most retailers sell the most product during the fourth quarter of the year, that is, the holiday season. To supply retailers with the proper amount of goods, manufactures typically conduct most of their production activity during the summer months, getting inventories ready for the fourth quarter push. Then, when the end of the year hits, retailers reduce manufacturing purchases as they focuses on selling through their inventory, subsequently reducing manufacturing sales.
Manufacturers with this type of seasonality often require a working capital loan to pay wages and other operating expenses during the quiet period of the fourth quarter. The loan is usually repaid by the time that the company hits its busy season and no longer needs the financing.
The Benefits of a Working Capital Loan
The immediate benefit of a working capital loan is that it's easy to obtain and lets business owners efficiently cover any gaps in working capital expenditures. The other noticeable benefit is that it is a form of debt financing and does not require an equity transaction, meaning that a business owner maintains full control of his company, even if the financing need is dire.
Some working capital loans are unsecured. If this is the case, a company is not required to put down any collateral to secure the loan. However, only companies or business owners with a high credit rating are eligible for an unsecured loan. Businesses with little to no credit have to securitize the loan.
Potential Drawbacks of a Working Capital Loan
A collateralized working capital loan that needs asset collateral can be a drawback to the loan process. However, there are other potential drawbacks to this type of working capital loan. Interest rates are high in order to compensate the lending institution for risk. Furthermore, working capital loans are often tied to a business owner's personal credit, and any missed payments or defaults will hurt his or her credit score.