Having enough working capital on hand can be a challenge for a business at any stage. Whether you’re a start-up getting ready to launch, an existing business looking to expand, or a seasonal business managing cash flow, there may come a time when your business needs a boost to fund your day-to-day operations.
Often, business owners assume that a line of credit is the correct type of financing to meet their working capital needs, but that may not be the case. In this article, Pursuit takes you through the differences between a line of credit and a term loan for working capital and also points out common mistakes that you should avoid.
Differences Between Lines of Credit and Term Loans
Lines of credit provide a maximum amount of borrowing for a set period (typically 12 months) to support gaps in a company’s cash cycle. Funds can be drawn down and repaid throughout the commitment period with the borrower making interest-only payments on a monthly basis. The lender typically requires the outstanding principal balance to be repaid in full at least annually. A line of credit is typically ideal for a business with cyclical needs for cash that can be repaid from revenue. For example, a line of credit can be used to purchase holiday inventory, which will be sold to generate revenue to pay down the line of credit.
Lines of credit are best used to meet short-term working capital needs that exist for less than 12 months. One common need results from business seasonality (e.g. purchasing inventory for a peak selling season). Another short-term need could be adding temporary staff to fulfill a short-term contract.
Term loans used for working capital typically can range from three- to seven-year terms depending on the lender and require monthly payments of both principal and interest. Principal balances are paid in full by the end of the loan term.
Term loans are best used to meet permanent or longer term working capital needs. For example, start-ups need a working capital line of credit for things like hiring staff, professional fees and filings, and anything else specific to getting a business up and running. For start-ups, it’s also wise to have working capital to cover six to 12 months of operating expenses to ensure there are sufficient funds available as business operations get underway, and while a business works toward becoming profitable. Term loans of this type are generally used in lieu of equity financing and provide “permanent” working capital.
For existing businesses, it’s advisable to have sufficient working capital to cover at least three- to six months of operating expenses to support slow periods. Existing businesses undergoing expansion have working capital needs similar to start-ups due to the addition of staff, increased inventory needs and other increased overhead expenses. Longer-term working capital needs like these are best met by term loans with longer repayment periods.
Both lines of credit and term loans are offered by traditional commercial banks as well as alternative community lenders. Each has their own qualification criteria, interest rates and terms. For advice on which loan is right for you, contact Pursuit’s Business Advisory Resources team.
Common Mistakes When Seeking Working Capital Financing
1. Businesses seek a line of credit when they really need a term loan
If your business is in the start-up phase, you will incur start-up costs and perhaps a few months of operating expenses before you begin generating revenues. Breakeven sales (e.g. your ability to cover your variable and fixed costs) often take up to a year to achieve.
If you use a line of credit to fund these working capital needs, you most likely will be required to repay your debts in full at least annually, as well as pay interest on your outstanding debts monthly. This can create a cash flow crisis, which leads to delinquent payments to your vendors, employees and possibly lenders—destroying your business credit score before you even get started!
A similar situation may occur if your existing business is growing or expanding and you choose to finance these needs with a line of credit. It may take longer than a year to generate the increased revenues needed to cover the associated implementation costs and operating expenses. You can create a cash flow crisis when it comes time for the annual repayment of your line of credit balance.
Another factor to consider with a typical line of credit is that it is renewed annually. This means that lenders can withdraw their commitment at their sole discretion, leaving your business without a source of funds –so make sure you have an alternative source of financing.
2. Businesses underestimate their working capital needs
Businesses often experience a financial pinch because they have not secured a sufficient working capital line of credit to support their business during its start-up or growth phase. Business owners may overestimate how quickly revenue will be generated or how quickly creditors will pay, or they may underestimate expenses and find themselves short of funds.
When this happens, a lack of working capital may result in missed opportunities. For example, there might not be enough money available to bid on a project, hire more employees, get a better deal on inventory, or purchase advertising. At worst, insufficient working capital can lead to late payments to vendors and creditors, damaged credit scores and even desperate borrowing from predatory lenders. It’s always a good idea to have some working capital on hand when real costs don’t exactly match your initial estimates.
3. Businesses don’t anticipate the timing of their working capital needs properly
If you do not give yourself sufficient time to shop for the best financing options, you risk making a bad decision by using fast and expensive predatory loans that are constantly being marketed to small business owners. While these lenders offer quick and easy applications and access to fast cash, the money often comes with exorbitant interest rates —annual percentage rates (APRs) of 50% or more are common.
Also common are rapid repayment terms and daily withdrawals from the business’s bank account. Before long these terms become burdensome and put businesses at risk. Pursuit has helped small business owners who were caught in a predatory lending trap refinance their debt to lower their monthly payments and improve their credit scores.
CDFIs and lenders offering SBA loans offer affordable alternative working capital loans with reasonable terms. However, make sure to give yourself the appropriate lead time from the time you apply to when you actually will need the funds.
If your business needs a working capital boost, contact Pursuit’s Business Advisory Resources team for guidance. Even if you don’t qualify for traditional bank financing, Pursuit has fast and affordable longer-term loan options available, as well as educational services and broad community networks to help you get the funding you need to support your small business’s success.