Introduction to working capital loans

Working capital loans (facilities) are used to finance a company’s everyday operations. Loan proceeds can be used to:

• Purchase inventory/seasonal merchandise
• Expand/remodel
• Pay off debt or taxes
• Get capital to finance equipment purchases
• Execute marketing and/or advertising plans
• Fund emergency situations

Working capital loans can come in the form of a loan or a revolving line of credit. They can be unsecured or secured. An unsecured loan does not require collateral while a secured loan is backed by company assets.

Working capital factoring involves the sale of accounts receivable to a specialized factoring company or a bank at a small discount. Unlike lending, factoring relies on the creditworthiness of the company’s client, not the company itself. To learn more about factoring, please visit our small business factoring page.

Working capital can also be obtained by using credit cards or a merchant cash advance. The latter is a loan extended by credit card companies against business’s credit or debit card sales. It is repaid using a percentage of these sales.

Any type of loan can be called a working capital loan as long as it is used to fund working capital. A lender will always want to know what the loan is used for and businesses should be wary of lenders that do not inquire about the use of proceeds (UOP) as such lenders can be predatory.”

Types of loans

Generally speaking, loans can be unsecured and secured. It is, however, hard to obtain a truly unsecured loan. Most loans are secured as lenders are usually unwilling to take repayment risk without collateral.

There are two types of secured loans: asset and revenue-based. Asset-based loans use company assets as collateral. These can include a company’s most liquid assets, such as inventory and accounts receivable. Hard money loans are asset-based loans that use property or equipment as collateral.

If a company does not have many assets, a revenue-based loan can be a good alternative. This type of loan is backed by the company’s historical and expected revenues. It can be faster to obtain because a collateral appraisal is not required. Interest rates and late fees on such loans can be higher to compensate the lender for the lack of collateral.

Any type of loan can be called a working capital loan as long as it is used to fund working capital. A lender will always want to know what the loan is used for to adequately price risk and ensure repayment. Businesses should be wary of lenders that do not inquire about the use of proceeds (UOP) as such lenders can be predatory.

Factoring, on the other hand, is not lending. Therefore, factoring companies are not usually concerned with how funds from factored invoices are being used.

Loan requirements differ from lender to lender and depend on the type of loan. Generally speaking, Loan requirements differ from lender to lender and depend on the type of loan. Generally speaking, lenders take into account the business’s financial health and ability to pay back the loan based on historical and projected future performance. For more information about requirements to take out an asset-based loan, please visit our Asset-based Lending page.

Non-bank companies, can also extend loans and usually have less stringent requirements. Business Factors works with clients with challenging credit profile that are unable to provide collateral.

Cost of a loan

Loans can be long- or short-term. Their cost depends on several factors including:

• The specific arrangement between the business and the lender
• The company’s financial health and amount of amount of time in business
• The borrower’s industry
• Loan type
• Loan duration

The cost of the loan can be quoted using factor, interest or annual percentage rate (APR). Factor rates (not related to factoring) are usually given as decimal figures or percentages and range from 1.1 to 1.5. The factor rate indicates how much should be paid back when the loan is due. Let’s take a look at an example:

• Loan amount: $100,000
• Factor rate: 1.1
• Loan term: one year

In this scenario, the borrower will have to pay back $110,000 by the end of the year. The difference between a factor rate and interest rate is that, in the case of the former, the interest is charged when the loan is underwritten so there is no benefit to prepaying the loan. By contrast, the interest rate is charged on the principal amount outstanding, so, if the loan balance declines, the business pays less in interest. Here is an example:

• Loan amount: $100,000
• Interest rate: 10% fixed
• Loan term: two years
• Repayment mechanism: bullet maturity (meaning the principal is due in one installment upon loan term expiration)
• Interest payable semiannually in January and June, starting in June after loan issuance

In this example, the business would pay $5,000 of interest in June of the year the loan was issued. Over the summer, the company accumulates $20,000 of extra cash that it decides to use to partially pay down the loan. Thanks to this, the interest payment in January of next year is only charged on the remaining principal amount, which is now $80,000. The corresponding semiannual interest payment is now down to $4,000. Thus, an interest rate arrangement in this case allows the business to save on interest by paying down the principal amount before the maturity (unless there are prepayment penalties, which are fees the lender charges if the principal is paid down early).

Annual percentage rate, or APR, is the interest rate plus all the fees associated with the loan. These can include closing and commitment fees.

Working capital loans are used to cover everyday business expenses, such as paying off debt or taxes, buying inventory or season merchandise and paying for marketing or advertising. These loans can be secured or unsecured and can come with a fixed or variable interest rate.”

Fixed and variable interest rates

Interest rate can be fixed or variable. A variable interest rate is usually tied to a benchmark rate, such as the London Interbank Offered Rate (LIBOR) or the federal funds rate. Both are benchmarks widely used in the financial industry to price loans.

A variable rate can be advantageous when the economy is doing well and the rates are low. But, if the economic cycle turns, the rates can go up causing the borrower to pay more in interest. The increases are usually gradual and, if the amount of the loan is modest, do not present an immediate problem. However, with multiple loans or higher principal amounts, the increase can pose a challenge. A prime example of this is the U.S. housing crisis that caused a wave of foreclosures when interest rates on multiple variable-rate loans went up.

Let’s take a look at another example:

• Loan amount: $100,000
• Interest rate: Fed funds rate+450 basis points (bps)
• Loan term: two years
• Repayment mechanism: bullet maturity
• Interest payable semiannually in January and June, starting in June after loan issuance

In this example, let’s assume that when the loan is taken out, the federal funds rate is at 1%. Thus, the first interest payment payable in June is $2,750. Next, let’s assume that in January the rate goes up to 1.5%. Now, the interest payment due that month is $3,000. For the next interest payment, the rate increases to 2% and the interest payment is back to $3,250. Granted, these fluctuations are not large but the impact could be more significant if the loan balance were higher or fluctuations greater.

Conclusion

Working capital loans/facilities are used to cover everyday business expenses, such as paying off debt or taxes, buying inventory or season merchandise and paying for marketing or advertising. These loans can take many forms depending on their collateral (secured or unsecured), ability to reborrow (revolving line of credit versus a loan) or type of interest rate charged (fixed versus variable rate). Secured loans are further subdivided into asset-based and revenue-based. Asset-based loans use assets, such as inventory or accounts receivable, as collateral. A subtype of asset-based loans – known as hard-money loans – use hard assets, such as property or equipment, as collateral. Revenue-based loans are secured by the company’s historical revenues. Any loan can be called a working capital loan as long as it is used for working capital. Loan requirements vary by lender but generally take into consideration company’s financial health and ability to repay. Non-bank companies usually have less stringent requirements. Contact Business Factors today to find the best lending arrangement for your business.