Working Capital Financing 101: Definition, Types & Tips
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In a constantly changing business climate, you need a versatile working capital financing strategy to grow and scale your business.
It ensures that you have the right amount of capital at the right place at the right time, giving you the ability to meet short-term capital needs while pursuing long-term growth projects and investments.
But what exactly is working capital financing? What are the methods of financing working capital? This article has the answers for you.
- What is working capital financing?
- Why do you need working capital financing?
- Types of working capital financing
- Which working capital financing method is the best for you?
- Some last words
What is working capital financing?
Working capital financing is a way in which businesses acquire new capital to boost liquidity and fund investment in short-term assets, such as accounts receivable and inventory.
With the capital received, you can free up cash for investing in new projects and growing your business, while having sufficient funds to pay for day-to-day operations expenses such as rent, payroll, overhead and others.
Why do you need working capital financing?
One application of working capital financing is for closing temporary cash flow gaps. This is particularly common among seasonal businesses, the cash flow of which could be gravely uneven throughout the year.
Let’s say you run an online store which sells sports and outdoor equipment. Summer is the peak season, and of course, sales stay low during winter.
Prior to summertime, it’d be best to stock up and prepare for the busy period. But you’ll need a lot of money to buy inventory! This is where working capital financing comes in — to fund your investment in short-term assets, that is, your goods.
Financing of working capital is also common among fast-growing businesses, or those who are looking to expand. The reason is that during periods of growth, you’ll likely spend more than you earn before you can reap the fruits of what you sow.
The extra pump of cash will allow you to focus your resources on growth, such as advertising, product development or new market penetration, all without the needs of working capital holding you back.
Types of working capital financing
There are many ways to finance your working capital. Below are 6 types of working capital financing that you can use:
- Line of credit
- Working capital loan
- Revenue-based financing (recommended!)
- Receivables financing
- Inventory financing
1. Line of credit
A business line of credit (LOC) is a revolving loan which gives you access to a fixed amount of funds. You can withdraw money within the pre-approved credit limit, and pay interests only on the amount borrowed. Once repaid, that amount becomes available for you to use again.
On the plus side, lines of credit are flexible. Funds can be withdrawn anytime you want, and there’s no need to apply for a loan every time you need extra cash. For these reasons, lines of credit are a great option for meeting short-term capital needs, such as advertising and inventory purchase.
However, there’s a downside to obtaining lines of credit. There’s a limit to the amount you can draw, there may be extra (and hidden) fees, and application procedures are often complex with long turnaround times.
Learn more: Line of Credit (LOC): Things You Need to Know
With an overdraft facility, you can withdraw money from your bank account despite having no balance in it. In effect, you’re “borrowing” money from the bank.
Similar to a line of credit, overdrafts have the benefit of being flexible. It allows for withdrawal of cash anytime, and has less paperwork compared with bank loans.
However, overdrafts come with serious limitations. Overdraft limits are often low unless your business has a strong credit rating. Interest rates also tend to be high, and most banks would require you to provide collateral for an overdraft.
3. Working capital loan
As its name suggests, this type of loan is used to finance working capital needs, i.e. everyday operations of a business. It can be a bank loan or cash flow loan.
(a) Bank loan
Bank loans are a rather conventional way of financing working capital. It’s known for having low interest rates (relatively, if you compare with online lenders out there), but limitations abound.
For starters, taking out a bank loan requires tons of paperwork and also collateral (e.g. equipment or cars) to secure the loan.
What’s more, loan repayments follow rigid schedules, which means you have to repay fixed amounts of money by certain dates, or you risk losing the assets that you provide as collateral.
(b) Cash flow loan
Cash flow loans are granted based on your business’s capacity to generate cash flow in the near future. The expected cash flow will be used to “secure” the loan.
An advantage of getting cash flow loans is that you don’t need to pledge tangible assets as collateral. But there’s a catch. You’ll likely be asked to sign a personal guarantee over the loan and have to pay higher interest rates.
4. Revenue-based financing
The many imperfections in traditional credit facilities have caused a new form of working capital financing, called revenue-based financing (RBF), to flourish.
In revenue-based financing, funds are given to businesses to finance their working capital or other needs. RBF platforms will then share a small percentage of the recipient companies’ revenue until the funding plus a flat fee is repaid in full.
The major advantage of RBF lies in its flexibility.
With a revenue-sharing model, you can comfortably manage the repayment — when business is good, you’ll repay more in that month; and when you have a slow month, you give back less. There’s no set repayment schedule, so you don’t ever have to worry about “keeping up with” repayments.
Oftentimes, applying for revenue-based financing is also quicker and easier than getting other forms of working capital financing, such as bank loans.
For instance, getting RBF funding with Choco Up is a paperless process, with minimal forms to fill and takes only 3-5 working days to process. In the best scenarios, funding could be available to you in as soon as 48 hours.
5. Receivables financing
Receivables financing is a type of financing arrangement in which you’ll receive cash based on your accounts receivable.
There are two main types of receivables financing: receivables factoring and discounting.
(a) Receivables factoring
Receivables factoring involves selling outstanding receivables to a factoring company.
Upon the sale of receivables, the factoring company will give you 70-90% of the receivables value upfront. The remaining amount, after deducting a factor fee and other fees, will be paid to you upon maturity of the receivables.
Apart from financing working capital and smoothing out cash flow gaps, receivables factoring has an ancillary benefit.
The factoring company, who has purchased your receivables, will be responsible for collecting money from your customers.
This saves you some time and resources in chasing after customers for payment, but the flip side is that customers will know you’ve sold the receivables. That doesn't look good as clients may have concerns about your company’s cash flow position.
(b) Receivables discounting
In receivables discounting, your company’s accounts receivable are used as collateral to borrow money.
The loan amount usually ranges between 80% and 95% of the receivables value. Upon maturity of the loan, you’ll have to repay this amount with interest and fees to the lender.
While receivables discounting doesn’t require expensive assets as collateral, and is much more accessible by small businesses, this type of financing is quite costly.
Be prepared to pay for the many fees, such as origination fees, credit check fees, service fees, etc. if you consider opting for this as a working capital financing method.
Learn more: Receivables Financing: The Ultimate Guide
6. Inventory financing
Inventory financing is a loan (or line of credit) made available for businesses to buy inventory.
Instead of using property, equipment or cars as collateral, the purchased inventory will be used to secure the loan.
The good thing about inventory financing is that it prevents your own money from being tied up in goods.
That’s because the inventory loan will subsidize your inventory purchase, so you can spend your financial resources elsewhere, such as on marketing and growth. The tricky situation where most of your cash is spent on goods is, therefore, less likely to occur.
That being said, inventory financing has a number of limitations. To begin, loan amounts are usually restricted to 20-65% of your inventory’s value, and lenders often demand that the borrowed money be used for inventory purchase only.
Besides, since you aren’t giving any “valuable” assets to secure the loan, higher interest rates usually apply to compensate for the increased risks of lending to you. Inflexible, automatic repayment may also be required.
Learn more: Inventory Financing: Everything You Need To Know
Which working capital financing method is the best for you?
As with many other business decisions, there’s no standard answer as to which working capital financing solution is the best.
That said, below are some considerations to help you evaluate which method suits you most:
- Use of capital
- Amount needed
- Repayment timeline
- Cost of capital
- Business type
1. Use of capital
“How do you intend to use the money?” is the first question you must ask yourself.
Purchase of goods, new hires and advertising are common reasons for getting working capital financing, but not all financing options can lead you on these paths.
Inventory loans, for example, can only be used to buy goods. Choco Up’s RBF funding, on the other hand, can be spent in any way you want. We’ll even tailor the funding plan for you, helping you get the most out of your new funding!
2. Amount required
Working capital needs of different levels call for different financing options.
If you simply need a small amount of extra working capital, then lines of credit and overdrafts may be reasonable choices.
However, if you’re looking for a sizable sum to, say, stock up for peak seasons or bring in a new recruit, then revenue-based financing would be a better fit.
3. Repayment timeline
When getting working capital financing, think about how you want to repay the money.
A word of advice: avoid fixed repayment by installments whenever possible. Having to set aside a fixed sum regularly to repay the debt would add a lot of pressure to your cash flow, especially during the low season.
The costs of overdue payments are high as well. You’ll have to pay extra interests, and the collateralized assets (if any) may be seized and sold by the financier.
4. Cost of capital
Every form of working capital financing comes at a cost, but you have a choice as to how much you pay to get the capital.
For example, the cost of capital in bank lending is the interest on loan. The costs involved in inventory financing are usually higher, considering the multifarious fees that you’ll be charged.
Meanwhile, the cost of capital in revenue-based financing is a small flat fee. At Choco Up, we promise that it’ll be the one and only fee you pay. There’ll be no hidden surprises. Click here to learn more about financing your working capital with Choco Up.
5. Business type
Last but not least, the working capital financing options available to you are closely tied to the nature of your business.
To give an example, online businesses are often deemed “high risk” by bank lenders. Operating with an asset-light model, digital merchants may not have the requisite assets to collateralize a loan either. Bank loans are therefore less readily available for these companies.
Likewise, software companies may not have inventory, receivables or assets that are needed to secure a loan. In this scenario, revenue-based financing would be an ideal choice.
Some last words
Whichever working capital financing method you pursue, having adequate capital is just the first step of running a business.
At Choco Up, we help businesses succeed on their own terms, giving them the right tools, assistance and resources to grow and expand at scale. We’ve helped clients like BuzzAR and eBuyNow grow their user base and revenue by 10X and 5X respectively.
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