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Working Capital Loan

Imagine you are the owner of a company, and in seven days, the salary day for employees comes. An extensive supplier pays the bill under the contract only after three weeks because he asked for a deferred payment.

Or another example, Oliver sells fur coats. In winter, the demand for goods is high, and in summer, no one buys fur coats. And if the company does not have a financial cushion for such a case, we know how to save it. You do not need to borrow significant amounts. So in Canada and not only, you can take out a working capital loan. The day has come to learn more about it.

Key points about Working Capital Loans

  • A working capital loan is money that the bank gives immediately so that the company can cover daily operating expenses.
  • Working capital financing is not intended to purchase long-term assets or investments.
  • The target audience is companies with high seasonality or long cycles of transactions.

Working capital in simple terms

Sometimes entrepreneurs do not understand how this can be – there is profit, but there is always not enough money for the company’s expenses. If we all lived in an ideal world, where there would be no delays in payments from customers and illiquid stocks in stock, we would immediately settle accounts with suppliers.

Then all the profit would be in money, but we don’t live in an ideal world. Most likely, customers ask us for deferred payments. We have stocks that we keep in stock and cannot sell.

Working capital is the company’s frozen money. This money is in goods in stock or with our customers or suppliers. In other words, this is accounts receivable. Profit and cash are connected through working capital.

Working capital formula = inventories + accounts receivable – accounts payable.

Working capital consists of:

  • stocks
  • accounts receivable
  • accounts payable

Stocks:

  • raw materials and materials that are in production
  • work-in-progress is something that we have not yet thoroughly done and have not brought to the finished product
  • goods in stock
  • goods on the way to customers

Accounts receivable or “we owe them.”

  • indebtedness of suppliers who have to ship the goods for which we paid an advance
  • the debt of customers who owe us money for the goods that we shipped to them

Accounts payable or “we owe.”

  • indebtedness to customers when they paid for our goods, but we did not ship it
  • indebtedness to suppliers to whom we have not shipped the goods
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Entrepreneur’s mistake

Sometimes we get $ 1,000 in advance from clients, 50% of the contract amount, and we think the client owes us another $ 1,000. Unfortunately, this is a mistake. We owe the client $ 1000 because we did not provide the service.

We can evaluate the effectiveness of working capital management. There is such an indicator as “turnover” in days. There is a turnover of stocks. We count for what period we will have enough stock in the warehouse if we do not buy anything. Turnover of accounts receivable shows us how long we defer payment to buyers or how many days we pay in advance to suppliers.

Accounts payable – for how long suppliers give us a deferred payment or for how many days in advance customers pay us in advance. We count the turnover period in days to determine, for example, how many days the goods are in stock. It is critical when the period of goods retention grows. At first, it was 15 days, then 20, 30. And if we don’t count it, we don’t manage it.

There is no magic formula that could tell us what the turnover period of working capital should use for the company. We need to maintain a reasonable balance between the company’s goals and understand what is critical for us.

Working capital is the business’s assets that “come and go” over a certain period, for example, for a month. There are businesses whose incomes depend on the season – seasonal or vary depending on the ups and downs of the economy – cyclical.

Working capital loan meaning

A working capital loan is working capital financing given by a bank to cover the company’s short-term operating costs, such as:

  1. salary to employees
  2. rental of premises and utilities
  3. marketing and advertising
  4. taxes
  5. research
  6. product development
  7. servicing the company’s debts

If the fur coat seller has no income in the summer but there are expenses in the form of paying bills, the bank comes to the rescue. Similarly, the bank saves you if the demand for your product is high, but the company does not have enough money to make and sell it. Your sales also have fallen since the dollar has risen. Some companies have recently entered the market and do not feel confident. They do not have stable and predictable profits.

A working capital loan makes it possible to increase production volumes and sell more than you can. Your earnings will grow without your investments, and you haven’t to attract investors’ money. 

The main mistake of entrepreneurs is that they take a working capital loan when cash is urgently needed. However, it is better to use this opportunity to save the company when you need to pay urgent bills. The purpose of a working capital loan is to help you out so that you can come up with a new way to earn money by studying the available resources.

Keep in mind that you shouldn’t invest credit money in long-term assets. There are other banking products with different interest rates for this. The bank saves you if the money is needed immediately. If you need to buy expensive equipment, use a small business loan. Often, a working capital loan is subject to high-interest rates. It is not suitable for the purchase of costly goods.

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Difference from other loans

The difference between a working capital loan and other loans is that the lender often provides a banking product at the collateral expense for your current assets.

Current tangible assets are:

  • money in bank accounts
  • accounts receivable
  • deposits
  • finished products that you want to sell
  • work in progress
  • raw materials and supplies

Loans for large purchases, for example, expensive equipment or transport, are secured by non-current assets.

Non-current assets are:

  • transport
  • buildings
  • earth
  • equipment
  • facilities

The bank carefully studies the nuances and checks your solvency before approving a working capital loan. The bank evaluates the value of assets and their profitability and compares assets against debt. The time during which the company exists, the average monthly income, and sales forecasts for the near future are essential to the lender.

A working capital loan can be secured and unsecured. A provided loan is when you leave something similar in value as collateral to the bank before you get a loan. These are usually accounts receivable or invoices. Often banks ask to have access to your account to charge payments automatically.

Unsecured working capital loans are less common; moreover, they give to companies with a high degree of trust. Interest rates are usually higher because the lender risks being left with nothing. All the bank can do is collect the money through the court and, after, can recover the debtor for years.

If you own a small organization and don’t need large loans, some banks approve credit cards for business. The bank can provide a working capital loan secured with your assets, accounts receivable, and factoring. Factoring is when you sell your accounts receivable for a smaller amount in exchange for money here and now. Invoice factoring allows small businesses to get cash quickly without applying for a traditional loan and through a lengthy loan application process.

A working capital loan is also distinguished because it is called a “demand loan.” That means that the bank can “ask back” the money at any moment.

The entities providing the loan also differ. The prominent players in the market are alternative online lenders. On their website, you can find flexible terms and simple requirements for loan approval.

If you collect a package of documents and go to an offline bank, the approval process can take a long time. Usually, there are several stages of passing checks. A bank can refuse you at one of them, and you will lose time.

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Advantages of a working capital loan

  1. You get a working capital loan immediately with good initial data and a trust rating.
  2. There are unsecured working capital loans – this is when you do not mortgage your property to the bank in exchange for money, and if you do not pay for a long time, all the bank can do is sue you and recover the amount after the court decision comes into force. No one will take away your property right away.

Cons and disadvantages

  1. A bank may link the loan to the personal loans of the business owner. Late payment may affect the personal credit history of the owner.
  2. High-interest rates.

Types of working capital loans

  1. Cash advances to the seller. You get a working capital loan, and pay for it from the company’s sales, do not forget that some lenders charge an additional percentage of sales.
  2. Short-term business loans. The plus is that you don’t have to take out large amounts, unlike conventional business loans. The terms range from 6 months to several years.
  3. Invoice financing. We are talking about an advance on the company’s accounts. You pay this advance gradually as your customers pay their bills. Do not forget about the bank’s commission.
  4. Factoring of invoices. We’re talking about a one-time deal. You sell unpaid invoices for less than they usually cost.
  5. Working capital loans from the Business Development Bank of Canada (BDC) to replenish working capital. This bank has a specific target audience – entrepreneurs. He gives out a working capital loan that can cover your daily expenses. The advantages are that the bank does not take your assets as collateral, and the loan repayment terms are more flexible.
  6. Credit line – the bank approves a specific limit of money and issues them in parts, not at a time.
  7. Business credit cards for small amounts.

Consider these points when choosing a bank.

  1. Think about how you want to get a working capital loan – immediately or in parts? Do you want to get money quickly? Take an urgent loan. Need cash as needed? Use credit lines.
  2. Study the rules of the bank. The procedure is essential – how to repay the loan and what interest the bank charges. What happens if the payment is overdue by one day? Are there any credit holidays? Please note that each bank has its own rules, which should not contradict the law. There are banks with good conditions but with bonded rules. You will pay the debt monthly, and fines and interest may differ.
  3. Not all lenders give free. Someone takes an additional fee for giving you a working capital loan. It is a reminder of how important it is to study the rules of each bank.
  4. Find information about the bank’s support service. How quickly will they come to the rescue if you have a question or a problem? Study consumer reviews of online support services.

How to get working capital financing

This process will depend on many factors. For example, the type of loan and the rules of a particular bank are essential. We have universal instruction.

  1. Think about whether this type of loan is suitable for you. Also, estimate how much you need and for how long. Analyze the situation in the company. Does it meet the goals of a working capital loan? It is essential not to mistake the type of loan.
  2. Check your credit score. Lenders evaluate the credit scores of both your business and personal scores.
  3. Make a sign in Exel where you compare banks and their banking products by different indicators. Remember that each bank has its own rules, interest rates, and conditions. Don’t forget to read customer reviews. Who will be your lender – an online bank with a convenient application in which you can solve any issue or an offline bank with an office?
  4. Prepare a package of documents. Usually, there is a list of documents on the website of each of the banks. If you forgot something, a bank employee would ask you to provide additional papers. Usually, banks want to see what loans you have and how conscientiously you paid them. They also request tax returns and statements on the movement of funds for a specific period from your account. This way, you can confirm your solvency.
  5. Apply for a working capital loan. Upload the documents via the online platform or contact the bank’s branch and make copies of the papers beforehand. You can track your application online in some banks, which is very convenient.
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Why is it important to read the contract carefully

Remember when you buy something inexpensive, for example, small household appliances. Sometimes we don’t read the contract because it’s easier to sign it immediately than keep the manager waiting.

But this article is about loan agreements. Some people also do not read them and then discover that the lender exposes inadequate fines for late payments or imposes additional services that they do not need after the contract.

People are suing the bank but lose because THEY signed the contract THEMSELVES. 2 days late payment? Hello, here is your fine and interest. The bank’s lawyer drew up the contract, you were ashamed to waste the manager’s time, and now you are wasting your time and nerves.

Remember that there is always a way out. Always read the contract carefully before signing, or take a break and send the contract to your lawyer for a thorough check.

About working capital management

It is essential to count numbers in business – this is how we control finances. If we don’t own it, we don’t handle it. If we divide the price of the existing accounts receivable plus the amount of credit debt by the available assets, we will get the ratio of assets and liabilities.

Our task is to have investments twice as significant as liabilities. We are talking about the percentage of assets to penalties in the balance of 2:1. If we see a result of 1:1, then the situation is critical, and we have negative working capital. At the same time, the company can make a profit.

We mentioned above that we evaluate the effectiveness of working capital management when we use the indicator “turnover” in days. These are the days for which we count, for how many days we will sell the goods, sell the stocks. We look at how long we can pay for the delivery of goods and how many days it takes customers to pay us.

The contract often specifies one payment term for the delivery of goods, but the client asks for deferred payment or refuses to pay and stops contacting. Unfortunately, this is a frequent situation and the leading case of arbitration lawyers. Also, illiquid goods can lie in stock for a long time, and our capital is frozen instead of generating profit for the owner.

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Controlling working capital is just as important as managing our obligations to third parties. Minimally, we maintain a ratio of 1:1 and strive for a percentage of 2:1. Companies often experience difficulties solely due to accounts payable. The one who runs the company can make the wrong decisions, he seeks to reduce the gap and takes a loan to reduce the deficit and monetary losses.

And here, you should be careful because you immediately become indebted to the bank. You should include this obligation in the coefficient and recalculate the figures using the formula we wrote above. A wrong decision can lead to changes in the coefficient, and your business will become unprofitable.

A small percentage of companies have proportions of 2:1. Not to mention that 1/2 of organizations go bankrupt in 5 years.

A company with a positive amount of working capital can afford to take on more obligations, has more confidence in banks and has a financial cushion in case of unforeseen situations. The expenses of such companies usually do not exceed the income.

After an unsuccessful decision to use working capital financing, companies with a negative level of working capital resort to investor money or crowdfunding.

Is it worth taking out a working capital loan?

We need to make sure that we need working capital financing, and we can predict that we will be able to find a way to earn from this loan. It will allow us to stay afloat. Then it makes sense to use a working capital loan to remove a temporary deficit in finances.

For example, sellers of outerwear can take out a working capital loan to pay for a seasonal increase in stocks of goods. Owners of summer country houses apply for a loan to move from one season to another. But if we cannot plan the income that will cover the loan, the decision to take it will be wrong, and we will earn a negative coefficient. Proper income planning and financial accounting tables will help to avoid problems.

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September 13, 2022
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FAQs about Working Capital Loans

What is a working capital loan?

A working capital loan is a business loan intended to help your business keep the cash flow going so you can do day-to-day business operations.

How can I get a working capital loan?

You can get a working capital loan by applying through Comparewise. We match you with the best rate and provider for you.

What variables does working capital consist of?

Working capital is the company's frozen money. The formula is simple - you have to add up the value of the inventory of goods (reserves) with the income that you will receive in the future from your customers (accounts receivable) and deduct from there the money that you owe to customers or suppliers (accounts payable).

How do I get a working capital financing loan?

1) Think about whether this loan is really suitable for you and whether it meets your goals. 2) Evaluate your chances of getting a loan, check your credit rating, and do not forget that a personal loan affects the possibility of getting a future this one. 3) Compare banks and choose the best offer. 4) Find a section on the bank's website with a list of documents required for a loan. Collect a package of documents. 5) Submit an application through the bank's app or in an offline branch.

Who issues working capital loans?

The main players in the market are online lenders. They have more flexible loan terms and simple application approval requirements. There are also offline banks where the loan approval process can take longer. Which is better - online banks with convenient applications or banks with offline branches? It's up to you.

How to choose a lender and not make a mistake?

1) Think about how you want to get the money - immediately or in parts? Maybe you want to take a credit card if you need a small amount? 2) Сompare creditors and carefully study their terms and conditions. Fines, support service, interest rate - it all matters. For example, somewhere, there may be easy conditions for approving a loan, but large interest rates for delay or a monetary fee for issuing money. 3) Explore customer reviews on the Internet, but remember that not all of them can be truthful and objective.

What is the difference between working capital financing and conventional loans?

Most often, a working capital loan is secured by your current assets, whether it is money in a bank account or accounts receivable. Usually, it's money that you get here, and now, interest rates are usually higher than on ordinary loans.

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