What is a working capital loan and how does it work?

 

Working capital is the money that’s left after accounting for all your business’ short-term cashflow (in and out). It’s another way of looking at how much cash you’ve got available to keep the business going, even if all your revenue disappeared.

If you can see a shortfall in working capital coming up, it needs addressing. One of the most popular solutions is a working capital loan, which we explore in detail below.

Whether your business is preparing for a seasonal rush  or you’ve had a contract fall through, a working capital loan could provide the relief and runway you need.

 

What is a working capital loan?

With a working capital loan, you’re borrowing money to pay for the running costs of your business.

Most other business loans are used to invest in assets and opportunities. Working capital loans are used to pay the bills and keep the business running as normal.

These loans are arranged by banks and other lenders. Your repayment period is relatively short (think months, not years) and you’ll be charged interest.

 

How to calculate your current working capital

To work out your working capital, use this simple formula:

Current assets - current liabilities

In this case, ‘current’ usually means ‘within one year’. If you’re trying to work out what to include, use the following as a guide:

Current assets	All your cash Accounts receivable due within the next year Any assets you could convert to cash within a year
Current liabilities	All debts due for repayment in the next year, including accounts payable Total wages, utilities and other bills you’ll owe in this period Any other financial obligations due in the next year

 

Whatever is leftover is your working capital. You can look at working capital on a month-by-month, quarter-by-quarter, or year-by-year basis.

 

The different types of working capital loans

Businesses take out working capital loans for all sorts of reasons:

• Immediate cashflow issues (eg. overdue accounts receivable)

• Seasonal fluctuations in revenue and expenditure

• Diverting assets towards a growth opportunity

As such, there are different types of loan available.

 

Short-term working capital loans

A short-term working capital loan can be used to fill an unexpected gap in your finances – say, a late-paying customer or a delay to a project.

These loans are turned around quickly, getting you the funds in a matter of days. The repayment terms are relatively short, too - measured in months rather than years.

 

Long-term working capital loans

A longer-term working capital loan might be used in the event of a high-paying project falling through or due to economic pressures on the business.

Working capital loans are short-term financial instruments, so ‘long-term’ is only relative to the product. For working capital loans, long-term might mean six months or a little longer.

 

Secured vs. unsecured working capital loans

Some lenders will offer secured and unsecured options for their loans. (Some might offer only one type.)

For a secured loan, you’ll need to put forward collateral (eg. an asset of a quantifiable value). For an unsecured loan, the lender will check your business’ credit score and take other steps for due diligence.

Secured loans can have lower interest rates than unsecured ones, as they are considered less risky.

 

Line of credit

A line of credit is equivalent to your credit card or overdraft. It’s a financial agreement that lets you draw down and repay funds as you need them, rather than receiving a lump sum (as with a loan).  

These should be used for short-term, flexible borrowing. If you need a lump sum, a term loan might be a better option.

Not all lenders offer credit lines, so you might need to shop around for a provider.

 

How does a working capital loan work?

Although working capital loans are different from most other business loans (as their main purpose is to pay for ongoing operations, rather than investing in an asset), the process from start to finish is largely the same.

 

Application process

Once you’ve found your lender, you’ll need to complete their application form(s).

These can vary from lender to lender. Some are online, others use paper forms or in-person meetings. They’ll ask for lots of information about your business, from directors’ details to financial reports and their own risk assessments.

 

Eligibility criteria

Each lender has its own criteria for who they can lend to, often based on:

• The size of your business (revenue and/or number of employees)

• Your financial records and current position, potentially including information like your debt-to-equity ratio and credit score

• Know Your Customer (KYC) and Anti-Money Laundering (AML) checks for all directors and persons with significant control

Your lender should provide their eligibility criteria on their website or on request.

 

Disbursement of funds

If your loan is approved, you’ll receive the funds in your nominated account.

The nature of working capital loans means you’ll receive your funds much faster than with other loans. If you need help with working capital, you usually can’t wait three to six months to get it.

 

Repayment process

Once you’ve got the money, you’ll start the less-fun part – repayments.

You can expect repayment terms ranging from a few months to 18 months or so. You’ll be charged interest on the principal and follow an agreed schedule.

If you’re borrowing money to account for seasonality, you might be able to negotiate a schedule that starts as more cash comes into the business.

 

Tips for working capital loan applications

We asked Ian Flaxman, our Head of Growth Finance, to share the positive signs he hopes for in working capital loan applications.

Ian went on to explain: “If you’re expecting changes - growth, new products or markets - then their potential impact needs to be considered. Things like new customers’ payment terms, additional inventory levels, new suppliers and their credit terms.”

“We always consider applications case-by-case basis, with no prescribed debt-to-equity ratio. However, it’s difficult for us when we see modest tangible value in the business and/or little/no shareholder investment.”

 

Benefits of working capital loans

Working capital loans are popular and, for some SMEs, a normal part of doing business. As we’ve written many times, debt is not always a bad thing in business. Business owners use working capital loans in all sorts of beneficial ways.

 

Improved cash flow

Working capital loans can stabilise your cashflow, whether you’re in a strongly seasonal trade or are facing delayed payments.

As many business owners will know, revenue and cashflow are not always perfectly aligned. Working capital loans can provide security and continuity where accounts receivable can fall short.

 

Flexibility in business operations

We see business owners using working capital loans in all manner of ways. You could be securing salaries in advance of a hiring run or buying materials ahead of your biggest project to-date.

Loans like these give you freedom, flexibility and new possibilities.

 

Seasonal business support

In highly seasonal businesses, expenses need to spike so income can follow after.

Buying all the materials and stock, as well as potentially hiring additional staff, ahead of a seasonal rush can cost a lot. A working capital loan can give you the head start you need, with your resulting higher revenues more than repaying it.

 

Quick access to funds

In some cases, a business simply can’t wait for a month or two (or longer) for a term loan to be approved and disbursed.

Securing a working capital loan is, generally, a much quicker process than other types of borrowing.

 

Customisable loan terms

With these loans being used to fund operating costs, rather than a capital investment, some lenders can be more open to negotiation on terms.

You might be able to negotiate smaller initial repayments that scale up after a certain time or add or remove a few months.

There are no guarantees, but it’s always worth a conversation.

 

Risks of working capital loans

Borrowing money always comes with some risk and working capital loans are no different. You’ll need to be sure that you can handle the risks involved with funding your working capital with debt.

Ian suggests reconsidering a working capital loan application if you’re intending to borrow because of “losses, directors or shareholders taking excessive remuneration or poor working capital management – eg. ineffective credit management policies leading to delays in accounts receivable.”

 

High interest rates

Working capital loans can come with higher interest rates for a few reasons: their short terms, the perceived risk by the lender and the fact that many are unsecured.

Higher interest rates can make these loans much more expensive, relatively speaking, compared to longer term loans. This needs to be considered relative to the flexibility of only needing to borrow what you need for the time period that you need it.

 

Short repayment terms

Short repayment terms may put pressure on your cashflow. You need to generate the revenue required for repayments quickly - there is rarely a grace period before repayments begin.

 

Risk of overborrowing

Overborrowing can be fatal for businesses. We mentioned that well-managed debt can be good for business growth, but mismanaged debt can produce the opposite effect.

If you borrow too much money (or borrow at too high an interest rate) to consistently make the repayments, you risk repossession of assets, legal action or even liquidation.

 

Fees and penalties

With these loans typically having short terms and high interest rates, lenders have strict fees and penalties tariffs in place to mitigate their risk.

Your debt can quickly and substantially increase if you’re charged for breaching its terms. This can move you into being overleveraged or increase cashflow pressure.

 

Opportunity cost

In committing to a working capital loan, you’re giving up other opportunities. This is true for any financial decision you make. You’ll be:

• Using up some of your capacity for debt

• Dedicating a percentage of future revenue to repayments

• Spending borrowed money on working capital, rather than investments

 

How to choose the right working capital loan for your business

Choosing your loan or lender is complicated. There’s lots to consider and the right option for one business will be wrong for another.

Take time to review your options, as well as your financial position, looking at the following areas.

 

Assess your business needs

You need working capital, but that’s a fairly broad category. The product you look for will be determined by your reason for borrowing. Adding temporary staffing and having overdue invoices are two very different situations.

You might not even need a working capital loan. For example, if you’re borrowing to buy materials to complete a big order, you might be able to negotiate different payment terms with your supplier instead of using debt.

 

Understand different types of working capital loans

We’ve explained the different options earlier in this article, but you should do your own further research.

You’ll also have to work with what you’re given – some lenders might only be able to offer you a secured loan, for example.

Working with your accountant or your bank’s relationship manager can be especially useful, as they can share contacts and expertise to help your search.

 

Evaluate interest rates and fees

The cost of borrowing isn’t the only factor to consider, but it’s undeniably important.

Your loan needs to represent good value – in terms of the amount you’re borrowing, but also the cost of repaying it. It’s rarely a good idea to push your debt levels to their limit, as unforeseen issues could quickly overleverage you and create serious problems.

 

Check eligibility requirements

If you’ve found a lender you like, you’ll need to be sure they’ll take you on as a customer.

Lenders don’t use mutually agreed criteria, so you might be eligible for some lenders and not others. Their criteria should be displayed on their website or on request.

 

Why use Allica for your working capital loan?

You can access working capital loans through Allica Bank’s growth finance facility. Every Allica customer benefits from:

• Competitive interest rates

• Flexible and negotiable terms

• Real humans on the end of the phone

• Personal, not automated, underwriting

• Dedicated relationship managers for banking clients

• A bank built for SMEs and with a real understanding of their situation

Learn more about growth finance at Allica Bank.

 

Working out your working capital situation

Working capital loans are part of the package for many SMEs. The nature of cashflow, seasonality and uncertainty make it a normal and necessary tool to use at times.

Debts come with risks and working capital loans are a debt like any other. If you’re confident you can afford the repayments and impact on future cashflow, it might be a good choice for your business. 

As with any financial decision, the best starting point is to research your options and analyse your situation. Hopefully, this guide has set you on the right path.

Ready to discuss a working capital loan from Allica? Get in touch with our growth finance team. 

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Disclaimer: This is information – not financial advice or recommendation

The content and materials featured in this article are for your information and education only, and are not intended to take into consideration any particular recipients’ financial situation. The product details and interest rates referred to are correct at the time of writing.

The information does not constitute financial advice or recommendation and should not be considered as such. Allica Bank will not accept any liability for any loss, including without limitation to, any loss of profit, which may arise directly or indirectly from use of or reliance on such information.