Working Capital Loan

Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Working Capital Loan Meaning

Working capital loan refers to a company’s finance to meet its everyday operational requirements. It is not a fund that entities seek for long-term investments or asset building. Instead, the loan helps companies meet their short-term working needs, which they require repaying within a few months.

What Is A Working Capital Loan

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When the companies run short of funds but understand that the production would help them earn significant profits, they apply for working capital finances to fund the processes. As soon as the production yields considerable profits, they easily repay that loan.

Key Takeaways

  • A working capital loan is a loan taken by a company to finance its day-to-day operational needs for a short duration, including debt payments, rents, or payroll. 
  • The company takes a short-term loan to meet its day-to-day business requirements. 
  • A company’s liquidity can be measured by its working capital, which indicates its capacity to meet short-term cash requirements/obligations.
  • Large businesses usually have in-house resources to determine the working capital amount. In other cases, entrepreneurs can seek outside professional help from firms that help businesses meet their financial needs.

How Does A Working Capital Loan Work?

A working capital loan works best for seasonal businesses, which do not require a lumpsum to keep going. The companies apply for these loans to pay rent or buy raw materials, which lets them preserve their capital for the time being. For example, the company buys raw materials using such finances, begins production, manufactures the finished goods, generates income or profit, and repays the debtorsDebtorsA debtor is a borrower who is liable to pay a certain sum to a credit supplier such as a bank, credit card company or goods supplier. The borrower could be an individual like a home loan seeker or a corporate body borrowing funds for business expansion. read more using the same money.

Working capital cycle

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There can be many reasons why companies opt for such loans. For example, the company may have heavily invested in its capexCapexCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more; hence the shortage of funds for day-to-day operations is obvious. Using these loans helps them cater to such needs. In addition, there are instances where entities are unable to convert their debtors or investments or unable to make sales as expected. The working capital loan for businesses, in such scenarios, help them in finding monetary aid. 

Even when they have unexpected cash requirements, they can apply for it. Shortage of funds to take up new projects/sales orders or purchase raw materials at a lower market rate can also be one of the reasons behind taking up these loans.

It helps businesses or entrepreneurs focus on capital outlaysCapital Outlays,Capital outlay, or the capital expenditure, refers to the sum of money spent by the company to purchase the capital assets such as plant, machinery, property, equipment or for extending the life of its existing assets to increase production capacity.read more, project financing, expansions, new products, and ideas. Depending on creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more, a loan can be easily obtained from the bank at a low-interest rate. In addition, it helps the businesses settle their creditors and other expenses, which maintains the firm’s goodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company's net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company's net identifiable assets from the total purchase price.read more and causes smooth functioning of day-to-day operations.

Explanation Video of Working Capital Formula

 

Types

Before companies apply for working capital loans, they must be aware of the available forms. The most common types of working capital finances are – term loans, lines of credit, Small Business Administration (SBA) loans, and invoice factoring

Working Capital Loan Types

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1. Term Loans

The first on the list is a term loan, the definition of which often makes it appear as working capital finance, which is known for its short-term payment requirement. A bank or any lender offers the term loan to be paid within a set period, extending to 25 years. 

2. Line of Credit

This loan type lets companies obtain money as and when needed at different stages of the business. The business applies for these loans and does not receive money in a lump sum but rather as a lined-up credit, ranging from $2,000 to $250,000, as required during the draw period, extending to five years.

3. SBA Loans

SBA loans backed by the U.S. Small Business Administration are available mainly to businesses that have just started. Companies can obtain these loans to maintain their reserves and grow their business. 

4. Invoice Factoring

Invoice factoring is a uniquely identifiable form of working capital finances. Businesses sell all or part of the accounts payableAccounts PayableAccounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period.read more to another party in exchange for a fee. This third party offers factoring services and becomes the factor. These factors offer loans by purchasing the invoices as and when collected.

Eligibility

The working capital finances can be secured or unsecured. While the lenders approve the former against collateral, the approval of the other depends on fulfilling the eligibility criteria. For example, the approval of secured loans depends on the value of the property or asset backing the loan. On the other hand, companies need to have a high credit rating to be eligible for an unsecured loan per working capital loan terms.

Example

Let us consider the example below to understand the working of this type of financing:

The following details are available from the balance sheet of XYZ Ltd.

Operation/MaterialAmount Involved
Raw Material$1,000
Work in progress$800
Finished Goods$1,200
Current Investments$4,000
Short-term Borrowings$15,000
Prepaid Expenses$2,000
Short Term Loan and Advances$4,500
Trade Receivables$1,500
Trade Payables$2,500
Short Term Provisions$2,500
Other Current Liabilities$5,000
Fixed Assets$80,000
Cash and equivalents$10,000
Advance Tax$9,000

Considering the above details, the company calculates the current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more and current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc.read more, first:

Current Assets = Inventories (Raw material + work in progress + Finished Goods) + Current Investments + Prepaid Expenses + Short term loans and advances + Trade receivables + Cash and Cash Equivalents + Advance Tax

= $(1,000+800+1,200+4,000+2,000+4,500+1,500+10,000 + 9,000)

= $34,00

Current Liabilities = Short term borrowings + Trade payables + Short term provisions + Other current liabilities

= $(15,000+2,500+2,500+5,000)

= $25,000

Working Capital = Current assetsCurrent liabilities

=$34,000 – $25,000

=$9,000

This helps the company learn about the loan amount they would require applying for. XYZ Ltd. realizes that the manufacture of the products will let them repay easily. Hence, given their strong credit records, they apply for unsecured working capital financing.

Working Capital Loan vs Term Loan

Though term loans are one form of working capital finances, they differ in many ways. Let us check some of the major differences between the two loan options:

CategoryWorking Capital FinanceTerm Loan
DurationShort-term to be paid back within a couple of monthsShort, medium, and long-term, extending to up to 5 years
UseShort-term requirements, like buying raw materials, paying rent, etc.Long-term requirements, including business expansion, etc.
InstallmentsLimitedMultiple
DocumentationNone or minimumSignificant
InterestHighLow
CollateralMay or may not be securedSecured
AmountThe loan amount is small.The loan amount is high.

Frequently Asked Questions (FAQs)

How to get a working capital loan?

The lenders assess a company’s profile before approving a loan. Hence, to get the finance approved, here are the steps that the borrowers’ application passes through:
– Evaluation of the needs
– Checking the credit scores
– Comparing the lenders
– Arrange for all documents
– Submit application
Once the lenders find the application to be alright, they would offer the loan.

How to calculate a working capital loan?

This loan to be applied for could be obtained by determining the expenses required for the working capital requirements. The working capital needs can be calculated by subtracting the current liabilities from the current assets.

Are working capital loans a good idea?

Working capital finances are good to apply for. This is because they are instantly provided for short-term requirements. Plus, the formalities to be fulfilled are low, and the repayment is conveniently made. The best thing about these finances is that they can be obtained as and when required.

Recommended Articles

This has been a guide to Working Capital Loan and its meaning. Here, we explain how it works, its types, eligibility, example, & comparison with term loans. You can learn more about accounting from the following articles –

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