What is a working capital loan? Uses, types, pros and cons
Whether you're just starting or have a well-established, profitable business, keeping up with day-to-day operating costs can be an ongoing struggle — particularly if your business faces seasonal fluctuations in revenue. That's where working capital loans come in. They give a short-term cash boost that bridges temporary gaps — letting your business move forward uninterrupted.
What is a working capital loan?
A working capital loan is a short-term finance solution from a bank or lender to cover your company's day-to-day operations. The aim of a working capital loan is to help you keep operating or grow your business through temporary cash shortages.
What you can buy with a working capital loan
While reasonably versatile, working capital loans only finance short-term business needs. These include:
Growth
Purchase additional stock, hire more staff to meet demand, seize an unexpected opportunity or launch a marketing initiative.
Unexpected costs
A working capital loan can act as an emergency fund or cash cushion when unexpected costs crop up — for example, replacing essential equipment.
Seasonal fluctuations
Finance for business operations that experience cyclical, low-revenue periods.
Day-to-day business operations
Bridge financial gaps between collecting accounts receivable and repaying debts, and meeting payroll or accounts payable.
What you can't buy with a working capital loan
Working capital loans can't be used to buy long-term assets or investments. They're intended for short-term use only — other financing options offer better interest rates for long-term needs.
Why are working capital loans useful?
Working capital loans help address cash flow problems. They'll give your business quick access to funds so you can jump on opportunities as they arise, manage any short-term challenges, and maintain business as usual — all year round.
What are types of working capital loans?
Working capital loans fall into two categories — secured or unsecured. Secured loans (when you put up an asset as collateral) are the most common, as lenders have a level of security to fall back on. Unsecured loans, while less common, are also available. These typically have stricter eligibility requirements like a high credit rating, a longer-standing business and a history of good profits.
Secured loans = collateral required. Typically offer lower interest rates and higher borrowing limits.
Unsecured loans = don't require collateral. Good credit rating required and typically have higher interest rates.
Whether secured or unsecured, the main types of working capital loans available to businesses are:
Term loan
This is the most common type of loan. You'll be approved for the loan and receive a lump sum payment reasonably quickly. You'll have to repay this based on your agreed loan terms that set out the duration and repayment schedule.
Revolving line of credit
Unlike a loan, a revolving line of credit (also known as a business line of credit) gives your company access to a maximum pool of cash you can draw from whenever additional capital is needed. You'll only pay interest on the amount you draw, making it more flexible than a term loan. Revolving lines of credit typically have variable interest rates, meaning your interest payable will go up and down.
What are the advantages of a working capital loan?
The main advantage of a working capital loan is the ability to quickly (and relatively easily) bridge financial gaps. This helps keep your business running smoothly or geared for growth.
Address mismatched cash flow
Working capital loans can help your business through periods where incoming and outgoing cash flow aren't aligned. This can occur in small and growing businesses relying on payment of accounts receivables to fund day-to-day operations such as payroll and rent, and in seasonal sectors where covering expenses during downtimes can be a struggle.
Invest in growth
Working capital loans can cover growth activities. These include opportunities to bulk purchase at a discount, setting up for new lucrative contracts and purchasing inventory to prepare for anticipated busy periods.
Work to customised payments
Working capital loans typically come with customised payment schedules that are matched to the cash flow of your business.
Take action quickly
Working capital loans have minimal paperwork (compared to traditional loans) and are usually approved faster, so you get access to the cash quickly.
What are the disadvantages of a working capital loan?
If not handled correctly, working capital loans can hurt your business or be difficult to obtain. The main disadvantages are:
They can be credit-rating dependent or require collateral
Working capital loans for small or new businesses can be tricky to secure without collateral. If you personally secure the loan, missed payments or defaulting on the loan may seriously affect your credit history. If the loan is secured by business assets, defaulting can have a significant long-term impact on your business operations.
Loans won’t address underlying issues
If you're seeing a consistent shortfall that needs covering, it could indicate a bigger issue with your company's cash flow, prices, revenue or profitability. Longer-term issues won't be addressed by relatively short-term working capital loans, in fact, they can hide issues that require your attention.
Interest rates can be comparatively high
Shorter-term loans typically come with higher interest rates, and working capital loans are no different. Floating rates are vulnerable to changes in the market, and you may end up paying more interest than you predicted. Higher interest rates can make it challenging to use working capital loans to successfully fund significant growth opportunities.
What is the working capital formula?
Working capital — also known as net working capital (NWC) — is the difference between your current assets (such as cash, accounts receivable and inventory) and your current liabilities (such as accounts payable, payroll, rent or tax owed). If your NWC is negative, it shows your business has more liabilities than assets, and can indicate you're struggling to cover immediate costs. If you've a positive NWC, then your business should have adequate cash flow to meet immediate operating costs.
Working capital = current assets – current liabilities
Questions to ask when thinking about a working capital loan
A working capital loan can be an excellent option for your business, provided you go into it informed. When considering a working capital loan, be clear on these six questions:
1. What specific challenge are you aiming to address?
Understand your needs and whether you should be addressing an underlying issue before considering a loan. You should only take out a working capital loan to improve your company's overall financial position.
2. What terms and conditions do you need to be aware of?
Understand the loan term, interest rates, repayment schedule and any additional fees. Find out whether the terms allow you to adjust the repayment schedule or make payments without incurring penalties.
3. What is the true cost of the loan?
Put the appeal of a quick cash boost aside and understand the loan’s actual cost, including interest and fees.
4. What support and guidance are available?
Find out what ongoing support, advice or guidance the lender will provide during the loan period.
5. What information does a lender need?
Be aware of what's required from you for a working capital loan — particularly if you're likely to need one in a hurry. Some lenders ask for a business plan, while others may need revenue figures, tax records, invoice history and a personal guarantee.
6. Are there any alternatives?
Consider alternative forms of business financing that might better suit your needs. For example, would finance through an investor or a long-term business loan be a better option, or are you eligible for any business grants?
Working capital loan FAQs
What is the difference between a term loan and a working capital loan?
A term loan is a type of loan structure that's usually used for longer-term investments or outgoings. Working capital loans are to cover short-term, immediate, day-to-day operational costs.
How are working capital loans repaid?
Working capital loans are repaid depending on the agreement with the lender. Terms may vary significantly from lender to lender but are short-term and often tailored to match a company's cash flow.
What is the difference between cash credit and a working capital loan?
While these both provide short-term finance, cash credit is the same as a revolving line of credit — you can borrow as and when you need, up to a maximum predetermined limit. Working capital loans can be revolving lines of credit but more commonly involve lump-sum payments with more traditional loan structures.
Clarity, analysis and understanding
Working capital loans can boost your business when times are hard, or you need a little extra to get ahead. A solid understanding of your working capital lets you analyse your shortfalls and ensure a working capital loan is the best thing for your business.
With MYOB’s business management platform, analysing your working capital is easy — you'll have clarity on working capital because your accounts will always be up to date. Start your free trial today.
Disclaimer: Information provided in this article is of a general nature and does not consider your personal situation. It does not constitute legal, financial, or other professional advice and should not be relied upon as a statement of law, policy or advice. You should consider whether this information is appropriate to your needs and, if necessary, seek independent advice. This information is only accurate at the time of publication. Although every effort has been made to verify the accuracy of the information contained on this webpage, MYOB disclaims, to the extent permitted by law, all liability for the information contained on this webpage or any loss or damage suffered by any person directly or indirectly through relying on this information.