Updated July 19, 2023
Introduction to Working Capital Loan
A working capital loan is a type of loan, mostly in advance, raised by a business to run its operational or day-to-day expenses, such as daily wages, bills, urgent cash needs, etc, covering most of the short-term requirements.
Companies often take loans to raise capital assets, finance projects, and meet long-term obligations associated with their businesses. However, this does not consider the funding of the business’s short-term needs. To provide working capital to manage short-term needs, companies are financed by a working capital loan.
Features of Working Capital Loan
Some of the features are:
- Rate of Interest: Every loan is raised by paying a certain interest cost. Short-term loans, such as working capital loans, have higher interest rates
- Eligibility: Eligibility criteria can vary from collateral requirements to credit ratings
- Performance Measure: From the business perspective, a working capital loan should effectively address the needs for which it is raised. In this regard, measures such as liquidity ratios, particularly quick and cash ratios, working capital requirement, and cash conversion cycle are useful.
How Does it Work?
The main feature of such loans is that they are raised for shorter periods and satisfy operational needs. Working capital management is important for businesses with bigger supply chains and intensive operations requiring operational expenditure allocation on shorter terms.
In such businesses, it is raised to fund those aspects of supply chains that are either short on funding or require frequent funding for their operation. Take, for example, a product-based business with retail management ingrained in its supply chain. The product is supplied to retailers during the early morning, and any perishable product is returned for return or replenishment. This might require frequent warehousing and transport needs, which call for certain expenses. The product-based business manages such expenses on a daily basis, without which the business’ retail management will not thrive.
Example of Working Capital Loan
A retail store owner has managed $10,000 in free cash this month. His credit sales are worth $2,500, due on the 1st day of the next month. He owes $4,000 in payments to vendors due on the 30th of this month. How much working capital loan should he raise to meet business expenses of $22,000 for the next month? As we know that 4 accounts need to be looked at – Free cash, credit sales, Payables, and Operating expense (for next month).
The working capital cycle indicates he is left with $10,000 + $2,500 -$4,000 = $8,500 at the start of the next month. To satiate the working capital needs of $22,000 for the next month, he should raise $18,000 more, which is the working capital loan he can apply for.
Types of Working Capital Loan
Some of the most common types are:
- Overdraft: A bank loan extended for a short period of time. The borrower gets a specific upper limit for expenditure under this loan facility. The borrower repays the interest, and exceeding the limit may attract higher charges.
- Credit Facility: This facility is often used when manufacturers purchase material from their suppliers who extend trade credit which is a function of bulk buying and duration of repayment.
- Equity Funding: Such a loan facility is useful for daily business needs and comes from the owners’ resources.
- Other Examples: bank guarantee, letter of credit, bill discount, account receivables, etc.
Who Needs Working Capital Loans?
Businesses, irrespective of size and nature of operations, need working capital loans to some extent. Larger businesses, such as those within the manufacturing sector, require such loans to catch up with working capital management. Manufacturing industries have huge fixed assets that generate tons of products and millions of revenues. Such industries can not afford to fall short of funding at any point in time. Businesses that have features of seasonality or cyclicality often use the facility of working capital loans. Such businesses have alternating high and lean sales periods with distinct cash flow needs.
Uses of Working Capital Loan
- To fulfill operational business requirements, such as daily bills, short-term or frequent rentals, daily wages, etc.
- Satisfy requirements such as bridging delays in payments.
- Stocking up inventory if there is a discount or seasonality related to the purchase.
Working Capital Loan vs Term Loan
|Working Capital Loan||
|Duration||Short-term (up to 1 year)||Long-term (3 to 10 years)|
|Need||Operational expenditures||Capital expenditures|
|Process||Easy to get||Hard to get|
|Requirements||No collateral, but good credit rating for shorter loans, no legal requirement||Collateral is a must, and legal and credit requirements stringent|
Advantages and Disadvantages
Below are the advantages and disadvantages:
- Useful in providing effective cash management when coupled with optimal working capital management.
- Secures the daily needs of the business and creates an influence on long-term viability.
- No requirement for collateral.
- Easy to fetch, process, and repay.
- No regulations on expenditure or usage.
- Short-term loans are attractive, but they come with bigger interest rates.
- Some working capital loans have regulations around the minimum capital and hence become difficult to fetch without collateral.
- It may also be tagged with the creditworthiness of businesses, and in the event of repayment failure, businesses can attract poor credit ratings.
Working capital loans act as a cash cushion for businesses with vast operations, long supply chains, and intensive cash requirements. However, small businesses also raise such loans and can effectively address almost any cash/daily operational requirements. Supply chains can get affected by the cash conversion cycle, meaning cash movement starting from raw material purchase to sale of finished product/service, and hence working capital loan fills any gaps in the process of this cycle.
It helps boost working capital management and improve business sales. An important feature is estimating working capital requirement that neither creates cash shortfall nor leaves high-interest charged excess cash within the business.
This is a guide to Working Capital Loans. Here we discuss the introduction to working capital loans along with the working and types. You may also have a look at the following articles to learn more –