What Are Working Capital Loans, and Why Do Businesses Need This Type of Funding?

When small to medium-sized businesses lack the working capital to finance their daily operations, they invariably start looking into external funding options, either from a bank or non-bank lender. Companies that find themselves in an abrupt and unexpected shortfall need expedient access to financing in order to keep up with their lease payments, debt obligations, and employee payroll.

This type of financing is called a working capital loan. Put simply, working capital loans represent a type of financing that businesses use to cover their day-to-day operations when they encounter an expected or unexpected shortfall. These loan products can be either secured or unsecured while their term lengths vary. With some exceptions, working capital loans typically entail a shorter repayment period.

In the sections below, we’ll discuss the different types of working capital loans for small businesses before listing several common reasons companies seek them out.

What are the different types of working capital loans?

Working capital loans have become increasingly popular among the small business community. These business lending products provide an effective means of financing companies that need the additional funding to continue operating, capitalizing on time-sensitive opportunities, and driving their long-term strategic growth initiatives.

As you start the search for new funding opportunities, here are the different business loan types you’re most likely to encounter:

Short-term financing

As mentioned, short-term financing products are among the most common types of working capital loans that businesses use to cover their essential operating costs in the event of a financial shortfall or if they have to make a considerable investment but lack the liquidated assets to do so within the necessary timeframe.

Short-term working capital loans typically include a fixed payment period and interest rate. Depending on your application, asset holdings, credit profile, and relationship with the lender, loans of this type may be secured or unsecured. Some short-term working capital loans may require businesses to collateral assets to secure the note, while other products, assuming the borrower is qualified, may waive this condition.

Business lines of credit or bank overdraft facility

Businesses that need flexible working capital solutions most often prefer lines of credit. When companies apply for a line of credit, the lender looks at the company’s balance sheet and credit profile to determine the maximum allowable loan amount.

Once the bank establishes the borrowing limit on the line of credit, it functions like a revolving consumer trade line. Borrowers can use the funds as needed before paying the balance back down to reaccess the available credit and cover their expenses.

Not unlike consumer credit cards, business lines of credit only allow you to use funds up to the approved cash limit without facing penalties. Likewise, borrowers are charged interest on only the amount withdrawn. This differs, of course, from a term loan that is dispersed in one lump sum, and the borrower is required to pay interest on those funds over a fixed time period.

The biggest upside to a business line of credit is that borrowers can deposit the used amount to reduce borrower costs and save on interest.

Trade credit

Trade credit is an agreement between current or prospective suppliers that provide the working capital. Typically, suppliers will use the trade capital loans to incentivize large, bulk orders of their inventory.

Similar to any financial institution, the supplier will analyze the business creditworthiness, payment history, and documented cash flow before entering into a repayment contract and extending trade credit to an enterprise.

Accounts receivables

This type of working capital funding uses your confirmed sales orders as a means of qualifying the loan. Accounts receivable financing is best suited for companies that, for whatever reason, cannot fulfill an upcoming sales order but can show they have the accounts receivables to cover the purchase.

Before attaining accounts receivables of funding, businesses need to exhibit a strong credit profile, a history of timely payments, and a favorable credit rating.

Equity funding

Equity funding is a common source of business financing that relies on investment funding secured from private or personal sources. Business owners who already have lines of credit on their personal property or high-limit consumer trade lines may use these funds to invest in their businesses.

This would constitute a form of equity funding, one of the most practical types of working capital loans for recent startups or newer companies that need more seasoning before they can apply for business financing.

Factoring invoices

Factoring invoices represents a financing arrangement in which a business will sell a portion or all of its accounts payables to a third party at a value that is lower than the original value of the accounts.

These third parties are known as factor services. They issue working capital loans to companies by purchasing the accounts payable invoices and collecting these amounts from debtors at their original values.

Letter of credit

Letters of credit or credit letters are official statements from a bank affirming that a buyer’s payment will be received in full by the due date. If the buyer cannot cover the purchase payment, the financial institution that issued the letter must pay the full or remaining balance of the original purchase amount.

Buyers purchase letters of credit from banks and send these letters to the seller. Once the order is paid as agreed by the sender, the financier remits to the seller the complete balance due. The bank will then collect this amount from the buyer at the date established within the agreement.

Bank guarantee

Bank guarantees are granted by lenders on behalf of the finance application to cover their payment obligations to third parties. This type of working capital loan does not involve the transfer of funds to the business.

Instead, buyers or sellers attain a bank guarantee to offset potential risks associated with non-performance on a contract. The bank serves as a grantor who answers to the party requesting the guarantee in the event that the buyer cannot cover the third-party payment obligations.

What are working capital loans used for?

Working capital loans issued by banks, non-banks, and alternative lenders are typically short-term financing that helps companies cover their existing and ongoing capital expenditures, such as employee wages, commercial real estate lease payments, and debt servicing.

Working capital loans are similarly effective at helping business finance expansion products or take advantage of limited-time discounts on vital assets such as manufacturing equipment. This type of debt financing specifically targets the short-term needs of companies that, for whatever reason, lack the capital expenditures to pay for them.

Working capital loans benefit businesses in several ways. Working capital business financing allows companies to maintain their agility, enabling them to respond to unanticipated crises and respond to unforeseen opportunities by securing additional funding.

Short-term working capital loans help businesses subject to cyclical or seasonal operating models cover their expenses during slower times when revenue is low. The extra funding gives companies like these need additional cash on hand to supplement temporary revenue shortfalls.

In other scenarios, enterprises may access working capital loans to enhance their strategic positioning. For instance, if a business sees an abrupt and unexpected spike in demand, the company may lack the funding to increase its current production. In this case, the organization would seek funding to hire more operators, purchase additional inventory, and procure the equipment and real estate needed to cover the increased customer demand.

Working capital loans are also useful for helping businesses take advantage of limited-time supplier discounts that if not acted upon quickly may prove detrimental to the health of the business and future profits.

At the same time, companies don’t typically use working capital loans to finance long-term assets. Organizations that support long-term tactical projects are likely to find better financing terms for these kinds of investments.

Sourcing working capital financing for your business

For newer businesses and recent upstarts, finding a reliable source of business financing is no easy task. In these early stages, most business owners are forced to rely on their own resources.

However, once smaller companies hit a critical breaking point in their growth, they eventually need to start looking for ways to finance additional working capital and seek a capital line of credit.

That’s not to say that business owners can’t -or don’t- start their companies with traditional business loans, but this is definitely not the role of a working capital loan.

There are plenty of private and government resources available that help launch new upstarts, however, working capital financing is generally reserved for businesses that have been operating for some time.

On the whole, securing financing for an unseasoned business is usually more challenging for new companies than it is for businesses that have been operating for more than six months.

Loans for newer companies are certainly not impossible, however. Usually, before you can take out a loan to start a new business, you’ll need to demonstrate an impenetrable business plan and prime credit before a lender agrees to fund it.

The other downside to using a working capital loan to finance longer-term initiatives is that the interest rates are often higher than loans with longer repayment periods and the other types of private equity funding discussed above.

This is true of any upstart that lacks a reliable track record of cash flows. In this case, whatever financing you receive would be considered high-risk. Presuming the borrower has no prior business experience, the qualification process will be tied exclusively to personal credit history.

Finding a reliable business financing source at the outset can be a challenge, which is why most entrepreneurs start their enterprises by bootstrapping. As your company gets more established and gains more seasoning, however, you’ll find a multitude of business loan options to help meet your requirements.

Why do small businesses need lender-financed funding?

Under ideal conditions, small businesses shouldn’t have to seek outside funding to keep their operations running smoothly. However, to remain competitive, most growing companies will eventually have to seek a capital line of credit or some other form of lender-financed, short-term working capital after bypassing a critical growth threshold.

With operating costs higher than they’ve ever been, most small businesses don’t have enough reserve capital on hand to procure new real estate, transport vehicles, equipment, software technology, and other company devices necessary to keep pace with their industry counterparts.

In fact, the current business environment is so characteristically unpredictable that many organizations learn they need quick access to additional working capital to address unexpected revenue shortfalls or make urgent repairs on aging equipment. Without the additional funds, the business could be placed at risk of significantly disrupted operations that eventually lead to closure.

While finding the right financing for your business is rarely easy, especially since traditional credit conditions are tightening, there are plenty of alternative options available.

New Bridge Merchant Capital offers speedy funding after a comparatively streamlined approval process, especially when considered in light the hoops you have to jump through at a traditional bank.

Coming prepared with a positive credit rating and a strong business plan vastly improves your chances of finding favorable loan terms and almost always hastens the loan qualification process. No matter who you borrow from, the lender must understand the objectives behind the proposed loan and be reasonably convinced the additional funds will ultimately lead to a profitable outcome.

With this in mind, the last thing any lender wants is to issue a loan that worsens the business’s current standing. The financing party is, therefore, always committed to the success of your business, as this constitutes the most effective approach for mitigating its own risks.

Now, let’s look at a few more scenarios in which a small business may need access to working capital before diving into the specific details of how business loan products from New Bridge Merchant Capital can benefit smaller upstarts like yours.

Asset acquisition and strategic growth

While we’ve touched on this topic a bit already, it’s worth revisiting again. Any company that aims to grow must necessarily acquire new assets. The problem is, many small businesses simply don’t have the funding on hand to procure them and take this next step to advance their growth trajectory.

Upgrading Modern IT equipment and infrastructure accounts for two major expenses that even large, enterprise-level businesses can’t afford. Yet, without the latest technology, the company could expose itself and its customers to potential cyberattacks that may lead to a costly information breach. At the same time, failing to modernize its technology means the organization is unlikely to perform at the same levels as its industry competitors.

While IT isn’t necessarily a revenue-generating function, the return on investment (ROI) from a security and productivity standpoint is high. Having access to the latest computing devices and software could allow you to you double your output while decreasing your risk.

Whenever you invest in new company assets, remember to always conduct an ROI analysis to ensure the benefits of the loan outweigh the risks.

Servicing your existing debt

While long-term loans might be more effective for consolidating and paying off high-interest debt into a single payment, you can leverage short-term working capital to service your current debt obligations after discovering a revenue shortfall. The latter approach ensures that when businesses encounter times of lower revenue, they can survive long enough to see your historically profitable months.

If you decide to use a business loan or short-term working capital funding to pay off debt, make sure you’re doing the appropriate calculations to confirm that you are actually lowering your borrowing costs and not increasing your financial risk. This includes a careful analysis of all the closing fees, prepayment penalties, and additional costs with closing the new loan.

Preserve your business credit standing

Upon starting your business, you have no doubt discovered a multitude of factors that can negatively impact your business -many of which fall outside the typical small business owner’s control.

In addition to fulfilling your operational requirements, a working capital loan can help you preserve both your credit rating and reputation by giving you enough cash on hand to make timely payments. Not only does working capital help ensure smooth and continuous operations, but it is also a reliable way of preserving -if not boosting- your current business credit profile.

Every business has a credit score, and falling behind on payments with third-party vendors and suppliers is almost always detrimental. In fact, slow pays and credit delinquencies are two of the fastest ways a company can find itself in a hole that it may not be able to dig itself out of.

Once your credit rating falls, and the invoices start to mount up, you’ll likely find yourself with few lending options that could provide much relief by helping you cover the cash gap.

Improved cash management

Working capital loans help small business enhance their overall cash management to give business owners more control over advancing operational growth and profitability. If you want to improve your asset and cash flow balance chart while gaining peace of mind knowing you can weather a shortfall, working capital loans represent an effective means of achieving this.

Need access to fast and effective working capital lending solutions?

New Bridge Merchant Capital offers a diverse range of small business funding and working capital loans to recent upstarts like yours. We pride ourselves in streamlining the approval process and our repayment terms are equally straightforward.

Start exploring your business financing options now by connecting with New Bridge Merchant Capital online. Or, to discuss your unique requirements, reach out to one of our senior business financing specialists by dialing 844-228-0593 now.