What is a Working Capital Loan?
A working capital loan is a loan that is taken to finance a company's everyday operations. These loans are not used to buy long-term assets or investments and are, instead, used to provide the working capital that covers a company's short-term operational needs. Those needs can include costs such as payroll, rent and debt payments. In this way, working capital loans are simply corporate debt borrowings that are used by a company to finance its daily operations.
How a Working Capital Loan Works
Sometimes a company does not have adequate cash on hand or asset liquidity to cover day-to-day operational expenses and, thus, will secure a loan for this purpose. Companies that have high seasonality or cyclical sales usually rely on working capital loans to help with periods of reduced business activity.
Many companies do not have stable or predictable revenue throughout the year. Manufacturing companies, for example, have cyclical sales that correspond with the needs of retailers. Most retailers sell more product during the fourth quarter – that is, the holiday season – than at any other time of the year.
To supply retailers with the proper amount of goods, manufacturers 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, which subsequently reduces 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 the company hits its busy season and no longer needs the financing.
[Important: Missed payments on a working capital loan may hurt the business owner's credit score if the loan is tied to their personal credit.]
Types of financing include a term loan, a business line of credit or invoice financing, a form of short-term borrowing that is extended by a lender to its business customers based on unpaid invoices. Business credit cards, which allow you to earn rewards, can also provide access to working capital.
Pros and Cons 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 their 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.
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.