Table of Contents
1. What is a Working Capital Loan and How Much Liquidity is Recommended?
2. When to Consider a Working Capital Loan?
· Inconsistent Cash Flow
· Seasonal Sales Fluctuations
· Business Growth Spurts
· New Business Opportunities
· Emergency Cash
3. Types of Working Capital Loans
· Short-term Loans
· Invoice Financing
· Purchase Order Financing
· Credit Line Loans
· Equipment Loans
It’s been said that a small business owner usually has enough money to run his or her business for a good month. This statistic according to JPMorgan Chase, indicates that most Micro, Small, and Medium Enterprises (MSMEs) have a cash buffer for typical cash outflows that lasts them 27 days on average. Surprisingly, this length was previously considered optimal until a crisis like the COVID-19 pandemic struck the economy.
The month-long Enhanced Community Quarantine (ECQ), restricted most of our local MSME’s working capital. This means that most couldn’t continue paying their employees beyond one to two weeks after the ECQ while keeping their business operations running simultaneously. The money supply that keeps their working capital balanced was most likely suppressed due to a halt in spending for their products, or their clients were probably unable to pay on time due to the same hold up. Restrictions on our economy’s normal supply and demand of goods has had a tremendous ripple effect on our small businesses.
In this article we’ll be discussing what working capital is briefly, why businesses need to manage their working capital well, why some choose to take out a working capital loan regularly or why a working capital loan would be the right solution, and which one you should take during certain times of the business year.
What is Working Capital and How Much Liquidity is Recommended?
Working capital is used to fund the day-to-day needs of your business such as employee salaries and orders from suppliers. If you monitor your cash flow statement regularly, which every good entrepreneur must do to sustain their business, working capital is derived by subtracting your current liabilities from current assets. The difference is simply what you can use as working capital.
Ideally, a business’ working capital should be positive and that means your short-term debts or current liabilities should be smaller than your current assets (especially liquid assets or cash at hand). With a positive working capital, you’ll be able to fund your business operations as scheduled.
How much working capital liquidity would an average small business need? It’s nice to have a long-term working capital like big businesses, but it’s also a huge opportunity lost for investing in other things like high-tech machines that can yield a better performance for your business growth in the future.
When to Consider a Working Capital Loan
There would really come a time when, despite having tight controls on your cash flow, taking out a loan proves to be the best option to take. Sometimes, businesses aren’t able to collect on receivables at a time when multiple new projects are coming in or are unable to pay on debts which may incur additional costs.
A working capital loan should be used to keep your business running by funding daily operations. Taking out a loan should be done with precaution and if you’re unsure, here are some good reasons below:
Inconsistent cash flow- this happens when your clients don’t get to pay their invoices on time or your business’ inventory turnover takes a long time. Such factors directly impact your cash flow negatively. Instead of waiting to liquidate your invoices you can choose to be proactive by taking out a working capital loan.
Seasonal Sales Fluctuations- There are products that sell more during certain seasons of the year while demand significantly decreases during other seasons. For example, those who manufacture personal protective equipment experienced extremely high demand as the COVID-19 curve began to spike. Small businesses would need a working capital loan to shoulder business expenses when sales can’t cover these expenses.
Business Growth Spurts- This is usually for startups and businesses that are relatively new and still struggle in making ends meet as they are generally unprepared for growth spurts. A working capital loan should help cover payroll, marketing and advertising expenses to help with spreading the word, and in recruiting good employees.
New Business Opportunities- opportunities come and go, but for small businesses, most opportunities don’t knock twice. Instead of passing up on a good one, a working capital loan can fund a business expansion, a much-needed training, new equipment, and the like.
Emergency Cash- This is basically for all unanticipated disruptions that your business isn’t prepared for. A working capital loan can definitely help fix a problem that can arise unexpectedly.
When in doubt about how much you should be borrowing, let the actual amount you need guide you. Don’t take out a hefty loan that you can’t pay for as soon as your normal working capital liquidity gets back to normal.
For first time borrowers, get more tips here.
Types of Working Capital Loans
1. Short-term loans
These are loans that are usually for one-time use only and are meant to be paid within a year or less. This is basically the most suitable type of loan as working capital needs are generally, short-term. Why spend years paying a loan that funded a project or business need that lasted a few months?
These are issued to business owners in one disbursement and are to be paid in regular, fixed installments over 6 to 12 months. Short-term loans can usually be paid back in fixed or equal monthly payments that include both the principal and interest.
Learn more about the latest trending short-term loans in the Philippines here.
2. Invoice Financing
Invoice Financing is ideal for growing businesses. This type of working capital loan requires businesses to submit their invoice to the financial firm so that they may advance cash against future invoice payments. Since Invoice Financing uses your accounts receivable to secure payments, it’s not suitable for businesses that do not issue invoices to their customers.
The main advantage of invoice financing is that it allows business owners to get cash quickly without significantly impairing their ability to borrow in the future. Since they are merely advancing cash from future invoice payments, they are useful to address short-term cash flow requirements.
Invoice financing makes it possible to pay recurring expenses such as employee salary and overhead, especially if you need to invest in these types of expenses to fulfill commitments for new contracts. Invoice financing also helps balance your incoming cash with your business expenses. It’s also often the best fit to fund business growth opportunities.
Learn more about First Circle’s Invoice Financing here.
3. Purchase Order Financing
This working capital loan is similar to Invoice Financing wherein it finances a specific working capital need, but a purchase order is required in exchange. Purchase Order (PO) Financing is a good financing option for businesses that have growth opportunities with new or existing clients, but are hesitant to commit to those clients due to the significant cash requirements for fulfilling their orders. With this type of loan, businesses can fulfill more client orders than their current cash flow allows.
PO Financing works by simply sending your purchase order to the lender. Then, the firm will disburse funds to you directly, while you wait for your customer to pay you based on your agreed payment terms.
Learn more about First Circle’s Purchase Order Financing here.
4. Credit Line Loans
This can either be taken from a bank or online lending companies. Businesses are given a credit limit and they can take out a loan within that limit at any time. Companies can choose between a fixed or revolving line of credit, similar to a credit card, that can be borrowed and will be reset once the balance is paid in full.
This is suitable for businesses that need to take out a loan on a periodical basis, either from a bank or from an online lending company. For seasoned business owners who know their industry well or rely on market forecasts, they know that there are certain periods in the year that would really call for a working capital loan.
The difference between traditional banking and online lending companies when applying for a credit line however, is that while banks would offer better rates, application and approval takes time and effort. Also, collateral is required to take out a loan from banks. Additionally, startups and new businesses usually have slimmer chances getting a credit line loan approval.
Learn more about the difference between collateral and non-collateral loans here.
Online lending companies offer the most convenience and speed compared to traditional sources, let’s not count unofficial sources, a.k.a. your friendship lines. They are also much friendlier to new businesses, requiring less requirements as they work with other resources to complete their underwriting process and decide on approving or disapproving a loan application. Nonetheless, if you have a bad credit standing, a credit line loan from both banks and online lending companies may not be the right one for your business.
5. Equipment Loans
This working capital loan is particularly used to purchase equipment (including vehicles). One particularly attractive feature of this business loan is that the equipment being purchased can usually serve as collateral for the loan. However, equipment loans tend to be more expensive in terms of the interest fees and other charges of buying the equipment instead of paying for it in cash. It can also be restrictive as it will only cover the cost of the equipment, not including maintenance fees and other required accessories.
Banks also offer the following secured (loans that require capital), working capital loans below:
Post-Dated Check Discounting- Business owners can use their post-dated checks issued by customers to banks, supplemented by other documents like delivery receipts. This is ideal for working capital needs in lieu of an invoice.
Export finance- this loan is specifically suited for exporters for pre- and post-shipment financing requirements. Banks will fund the working capital need — cost to manufacture your export products — or provide finance while awaiting collection of your export receipts. A Purchase Order or Letter of Credit evidencing the order from your buyer must be submitted to us to avail of this loan.
Weighing in the Pros and Cons
To conclude, it’s best to evaluate your working capital needs. If you’ve got a lot of working capital gaps at the moment, prioritise. Taking out loans are not to be taken lightly. You eventually have to decide which one is the best option to take depending on the following:
- your business model;
- the specific working capital need;
- your eligibility in terms of the loan’s requirements;
- the interest fees and other charges;
- the loan term, the repayment method;
- and the benefits the loan can offer you.
If you’ll end up losing more in the long term by taking out a loan, maybe it’s also best to postpone and look for other options.
Nonetheless, the working capital loans mentioned above have proven helpful in times of need for small businesses who are able to weigh in the risk factors and choose a working capital loan that actually complements their cash flow management and operating cycle. Working capital loans are also increasingly becoming easier to access through Fintech, not having to worry about collateral and the delay in approval.
Last tip is not to lose sight of the possibility of business disruptions. It’s highly recommended to keep enough cash reserves saved up for a rainy day. The global economy may just be prepared to take on a second wave of the COVID-19 pandemic, but more disruptions are sure to rock economies in the future and the best means of survival is a well-managed working capital, sufficient cash reserves, and of course, other business contingency policies.
Need business financing today? Apply for one with First Circle by clicking here.