Small and medium-sized businesses (SMEs) often encounter difficulties when having to cover day-to-day expenses suddenly. Reasons for this can be manifold – customers not paying their invoices on time or a larger than expected orders which requires new stock etc.
In the past, we have received many questions from SMEs about working capital loans and realized that many companies struggle to understand the term correctly: after all, it is a loan to cover working capital, isn’t? That’s correct; however, there are numerous options available, and for SMEs it is crucial to understand the differences to find the financing that fits.
What is a working capital loan?
A working capital loan covers the day-to-day expenses of a business, including accounts payable, salaries and office costs. SMEs affected by seasonal fluctuations rely on these loans as it helps them cover periods of slower business activity. Working capital loans are normally short-term and repaid once a business hits its busy season or receives outstanding payments, and therefore no longer needs the money.
What are the different loan types?
There are different kinds of working capital loans available: smaller businesses might use their credit card or bank overdraft. Other–usually larger companies–use invoice finance. This allows them to borrow against payments due from customers. A merchant cash advance is yet another option – a regular small loan which is repaid by cash from future sales. And some business even borrow money in the form of a personal loan.
Is there more? Yes. Businesses are increasingly taking advantage of fully unsecured working capital loans. SMEs do not need to put forward any collateral or a personal guarantee in order to secure the loan. In addition, the financing is not tied to any future income or outstanding invoices which gives the SME more flexibility. And if a business has already taken out a longer-term asset-based loan, an unsecured loan can be complementary as there is no claim on any assets.
Long-term loan vs working capital loan
A working capital loan is designed to finance everyday’s working expenses in the short term. The loan should be flexible–for example no penalty fee for an early repayment–and easy to set up–preferably within a few working days. By doing so, business owners can take out a loan swiftly when required but still keep their borrowing costs low. However, SMEs should be aware that a working capital loan is not suited to purchase larger assets or make a considerable investment, as these normally require repayments over a longer period of time.
When looking for a working capital loan, what mainly matters is to have a flexible financing in place to be prepared for any short-term funding gaps. Ultimately, this will help SME owners focus on what’s most important–growing their business.
If you want to find out even more about working capital loans, read on here.
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Originally published October 16 2017 , updated February 24 2020