Capital Finance: Why Borrow Money To Get More Working Capital?
Capital finance: Working capital loans in [geoip_detect2 property=”city”] is one type of business loan, right?
Let’s explore capital finance to better understand the purpose of working capital (defining differences between current assets and current liabilities.)
To the extent that a business does not generate enough money to pay trade debt as it comes due, this cash therefore must be borrowed.
Traditional banks are the largest source of such loans.
Banks lend based on the following characteristics:
- The loans are short-term but renewable
- May fluctuate according to seasonal needs
- Follow a fixed schedule of repayment (amortization)
- Require periodic full repayment (“clean up”)
- Granted primarily only when the ratio of net current assets comfortably exceeds net current liabilities
- May sometimes be unsecured
- More often secured by
assets (e.g., accounts receivable, inventory
Advances can usually be requested from as much as 70 to 80 percent.
Most l
And to 40 to 50 percent of inventory.
Banks grant unsecured credit only (when they feel) liquidity and overall financial strength of business provide assurance for repayment of the loan.
You may be able to predict a specific interval…
It could be three to five months for which you need financing.
A bank may agree to issue credit for a specific term.
More than likely, you will need working capital…
You want working capital to finance outflow peaks in your business cycle.
Working capital is also used to supplement equity.
Most working capital credits are established on a one-year basis.
Although most unsecured loans fall into the one-year line of credit category.
There’s another frequently used type as well…
This is referred to as the amortizing loan.
This calls for a fixed program of reduction.
Usually on a monthly or quarterly basis.
And to get this type of business loan from your bank…
Your bank is likely to agree to terms longer than a year…
As long as you continue to meet the principal reduction schedule.
It is important to note that while a business loan from a bank for working capital can be negotiated only for a relatively short term…
It will be based on satisfactory performance.
And it can allow the arrangement to be continued indefinitely.
Major banks will expect you to pay off your loans once a year
This is known within the lending industry as the annual clean up.
And it should occur when the business has the greatest liquidity.
This debt reduction normally follows a seasonal sales peak…
And when inventories have been reduced…
Making allowances for when most receivables have been collected.
You may discover it becomes progressively more difficult to repay debt or “clean up” within the specified time…
Why does this difficulty usually occur?
Because your business is growing…
And its current activity represents a considerable increase over the corresponding period of the previous year.
You have increased your short-term capital requirement because of new promotional programs or additional operations…
Maybe experiencing a temporary reduction in profitability and cash flow…
Frequently, such a condition justifies getting both working capital and amortizing loans.
For example…
You might try to arrange a combination of a $ 15,000 open line of credit to handle peak financial requirements during the business cycle…
And $20,000 in amortizing loans to be repaid at $4,000 per quarter.
In appraising this example request…
A traditional bank will insist on justification based on past experience.
And future projections.
The bank will want to know:
How the $15,000 line of credit will be self-liquidating during the year (with ample room for the annual clean up)
And how your business will produce increased profits…
Including resulting cash flow to meet the schedule of amortization on the $20,000 portion in spite of increasing your business’s interest expense.
In fact, it all comes back to capital management.
And capital budgeting to finance business.
So a business loan has two major forms which is debt and equity.
Creditor money (debt) comes from trade credit…
Loans made by financial institutions, leasing companies, and customers who have made prepayments on larger-frequently manufactured orders.
Equity is money received by the company in exchange for some portion of ownership.
Sources include the business owner’s or entrepreneur’s own money.
That seed money could have been borrowed from family, friends, or other non-professional investors or from (venture capitalists).
Debt capital, depending upon its sources (e.g., trade, bank, leasing company, mortgage company)…
Comes into the business for short or intermediate periods.
And is repaid only when and if there is a surplus at the liquidation of the business – after all creditors are repaid.
Acquiring the funds depends entirely on the business’s ability to repay with interest (debt) or appreciation (equity).
Financial performance (reflected in the Financial Statements) and realistic, thorough management planning and control
(These figures are shown by Pro Formas and Cash Flow Budgets).
These are the determining factors in whether or not a business can attract the debt and equity funding it needs to operate and expand.
Business capital can be further classified as equity capital, working capital, and growth capital.
Equity capital is the cornerstone of the financial structure of any company.
Equity is technically the part of the Balance Sheet reflecting the ownership of the company.
It represents the total value of the business…
And all other financing being debt that must be repaid.
Usually, you cannot get equity capital at least not during the early stages of business growth.
Working capital is typically required to meet the continuing operational needs of the business.
This includes:
- Carrying accounts receivable
- Purchasing inventory
- Meeting payroll
In most businesses, these needs vary during the year.
It really depends on activities (inventory build-up, seasonal hiring or layoffs, etc.) during the business cycle.
Growth capital is not directly related to the cyclical aspects of the business.
The growth capital is usually required when the business is rapidly growing, and there are plans for expanding into another market…
This could also include the business plan being altered in a significant way.
And
Lenders of growth capital frequently depend on anticipated increased profit for repayment over an extended period of time…
They’re not expecting to be repaid from seasonal increases in liquidity as is the case of working capital lenders.
In fact, almost every growing business needs all three types:
- Equity capital
- Working capital
- Growth capital.
You should not expect a single financing program maintained for a short period of time to eliminate future needs for additional capital.
As lenders and investors analyze the requirements of your business…
They distinguish between three types of capital in the following way:
- 1) Fluctuating needs (working capital)
- 2) Capital is repaid with profits over a few years (growth capital)
- 3) P
ermanent needs (equity capital)
Capital Finance The Fundamentals of Borrowing To Get Working Capital…
If you are asking for a working capital loan…
You’ll be expected to show in detail how the capital loan can be repaid!
You’ll need cash (liquidity) during the business’s next full operating cycle, generally a one year cycle.
If you want growth capital…
You will be expected to show how the capital is used to increase your business…
The capital has to be enough to be able to repay the loan within several years (usually not more than seven).
If you want equity capital…
The equity capital in most cases must be raised from investors.
The investors take the risk for dividend returns.
This could be either capital gains or a specific share of the business.
The content in this post is part of ongoing: how to use capital finance series, the step-by-step hands-on guide to financing your small business…