Most businesses will experience periods of unbalanced cash flow during the year, making it difficult to pay workers, cover rent or purchase new equipment. Working capital loans are strategies to mitigate these uncomfortable times. There are many kinds available to business owners, two of the most popular being a business line of credit or a short-term loan.
We’ve put together a guide to these two standard options. Continue reading to understand the difference between working capital short-term loans vs. a line of credit.
What Is a Working Capital Short-Term Loan?
Working capital is the measure of a company’s short-term liquidity, determined by the difference between their current assets and current liabilities. Businesses with more assets than liabilities have working capital to use. Those with more liabilities might consider taking out a working capital loan over a business loan.
One type of working capital loan is a short-term loan. It is a fixed, lump sum cash payment a business can use to pay for daily expenses when they don’t have suitable liquidity. You can use this injection of money to cover day-to-day operating expenses, including wages, rent and debt payments, while also funding activities like marketing, sales and research and development.
These loans are especially beneficial for organizations that regularly deal with seasonal or cyclical sales, such as manufacturing businesses. Short-term loans can fill in the gaps during quiet periods and are repaid in monthly installments during the busy season when financing is no longer needed. Most repayment terms are set for 6 to 18 months, and you’ll likely need to take out another loan if you need more capital.
While some banks supply short-term loans, this type of financing is generally supplied through private, online lenders. Private business lenders provide a quicker, more streamlined process that allows businesses to get their hands on cash sooner than they would with banks. Qualifications are also much less strenuous than traditional banks and offer convenient customization capabilities to meet a business’ needs.
How Can You Use a Short-Term Loan?
Maintaining a balance of cash on hand to pay for everyday operating expenses can be a challenge. Working capital loans assist you in meeting those daily needs to temporarily help pay for aspects that keep your doors open. Businesses can’t use the money received from these loans for long-term assets or investments but instead to satisfy immediate goals.
Some of the common ways businesses use cash from their working capital loan include:
- Managing short-term cash flow needs.
- Funding payroll, rent and other immediate expenses.
- Mitigating the risk of delayed payments.
- Addressing cyclical decreases in revenue.
- Covering emergency costs.
What Is a Working Capital Line of Credit?
Like your personal credit card, a business line of credit (LOC) provides you with a specified revolving credit line you can utilize at any time. This flexible funding option enables you to access the cash you need and pay interest only on what you borrow. The lender will often set a maximum amount on how much you can use. As you continue repaying what you’ve charged, you can draw money again and continue the process.
Contrary to the lump-sum payment of a traditional small business loan, a LOC is a versatile financing option. Businesses can access funds when needed to address an assortment of areas, such as managing cash flow, purchasing stock and paying employees. Funds also tend to come with lower interest rates and higher credit lines than business credit cards determined by specific characteristics, including how long the current owner has been there and what their annual revenue looks like.
A business line of credit is available through traditional institutions and private online lenders. Acquiring a LOC usually involves a credit check and is subject to annual review. Lenders will usually want to see businesses with a minimum annual revenue of $25,000 or more. Many lenders also establish certain requirements, such as setting a minimum time-in-business restriction — typically around six months.
If you decide this financing type is right for your business, conduct thorough research to find a lender that offers transparent information regarding requirements, fees and general guidelines.
How Can You Use a Business Line of Credit?
When you open a LOC, you’ll receive access to a predetermined amount of funds via a business checking account, credit card or mobile app. Monthly statement reports will inform you about the credit used and interest charges. This funding is helpful for businesses looking for uninterrupted access to working capital to address business expenses as they pop up.
Many businesses experience seasonal variations in their cash flow, increasing their need for stability. A LOC provides security for unexpected dips in revenue and emergency expenses, working somewhat as an insurance policy. Unlike a business credit card, mainly used for transactional purposes, a working capital line of credit will help you obtain the necessary cash quickly.
A LOC gives you the funding you need, covering everything from routine operational costs and emergency spending to revenue-driving growth opportunities. While it may come with higher start-up costs, it will help you pay for a wide selection of expenditures, including:
- Marketing campaigns
- Equipment maintenance
- Daily operating costs
- Periods of low revenue
- Tax payments
- New hires
Secured vs. Unsecured Lending Options
Before taking out your loan, it’s crucial to understand your options. Working capital loans and lines of credit are available as secured or unsecured loans, differing only in terms of collateral. Let’s look at how each type works.
How Do Secured Options Work?
A secured loan is backed by collateral. When you take out a secured loan, your lender will apply a lien on an asset you choose. Once the loan is repaid, the lender will remove the lien, and your assets will be safe. However, if your business defaults or fails to repay the loan, the financial institution can seize your collateral as payment.
Collateral can be any physical asset you own or purchase with comparable value to the loan, including:
- Real estate
- Insurance policies
- Stocks and other investments
- Valuable collectibles
- Bank accounts
Lenders offer secured loans when your business’s credit score isn’t high enough to obtain an unsecured loan. Because of a lower risk for banks, you can receive a larger loan with lower interest rates.
How Do Unsecured Options Work?
Unlike a secured loan, unsecured lending options don’t require collateral, meaning there’s no risk of losing your assets if you cannot repay. Instead, lenders are entitled to collect the outstanding amount owed on your balance.
Unsecured loans are generally more difficult to obtain unless you have an outstanding credit score and a track record of debt repayment. Essentially, you secure your loan through your accounts receivable, showing you have enough revenue to complete monthly payments.
When a financial institution enters into an unsecured agreement with you, they take you at your word, with the lender assuming significant risk. The loan terms will generally reflect that risk, coming with higher interest rates and shorter terms.
Breaking Down Working Capital vs. Line of Credit
Wondering about the benefits and drawbacks of working capital loans vs. lines of credit? Keep reading to learn more.
Benefits of Working Capital Loans
Working capital loans are generally quick and easy to obtain and allow you to address your cash flow needs almost immediately with a convenient lump-sum payment. Many institutions can help you align these payments to your business’s cash flow, limiting pressure in low-revenue seasons. These lending options are also beneficial, as a form of debt financing, enabling you to keep total equity and control of your business.
Disadvantages of Working Capital Loans
While working capital loans have many benefits, they don’t come without their downsides. Working capital loans regularly come with higher interest rates to offset any associated risk. They can often be unsecured for businesses with high enough credit scores.
However, companies with lower credit scores will have to securitize their loan with valuable assets. Lenders will also tie smaller businesses with a shorter history to their owner’s credit, meaning any missed payments or defaults will result in a damaged personal credit score.
Benefits of Business Line of Credit
A business line of credit enables you to use cash based on your needs and pay interest only on what you use. This flexible funding option helps businesses cover seasonal and cyclical gaps while allowing you to increase your adaptability to address unexpected costs and growth opportunities.
During this time, you’ll also cultivate a meaningful relationship with your lender and improve your credit score with on-time payments, increasing your chances of acquiring beneficial business loan terms in the future.
Disadvantages of Business Line of Credit
Like a credit card, LOCs can be easy to overspend on while investing in your business, which could lead you to violate your agreement or be unable to repay on time. If this happens, your credit score will likely drop. While lines of credit have higher limits than credit cards, they usually come in significantly lower than traditional loans, which might not offer enough capital for expansion projects, investments in new equipment or other expenses.
LOCs are also known for having strict requirements and application processes, which isn’t ideal when you need cash quickly. Lenders often require various documents and information like tax returns, bank account information, a business plan and more. If you do become approved, you’ll experience high interest rates and an assortment of extra fees for account start-up, processing, maintenance and even late payments.
Access the Cash You Need With Porter Capital
If you’re looking to establish a consistent cash flow throughout the year, consider enlisting help from Porter Capital. We have worked with businesses across the country for over 30 years, offering safe and secure financial solutions to help your operations thrive. Our team offers high-quality working capital solutions with transparent terms and quick 24-hour funding capabilities.
With our streamlined application and approval process, Porter Capital can help you get your hands on the cash you need to meet your business demands with greater confidence. To get started, contact us online or call 1-800-737-7344 to speak with a specialist.