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Understanding Different Types of Working Capital

Jason Smith

Jason Smith

Senior Author

Jason Smith

Senior Author

Let’s begin with a simple question: Why do you need a business loan in the first place when it’s often said that going into debt for your business doesn’t always make sense. The reality, however, is that, that when your business is ready to hit the big league, and yet you don’t have the working capital to fund it, a business loan sure makes your dreams come true.

Understanding Different Types of Working Capital

The principal reasons for taking a business loan are when you wish to expand your physical location. This is more applicable to situations where you’ve certainly outgrown your prime office location, or your retail store or restaurant is having to cater to more customers that fit into the available space.

Since your business sure is booming, and you’re all ready to expand, however, doesn’t always mean that you have ready cash in hand to switch locations. A term loan may be required here to fuel the big move. Be it an additional location or just moving, up-front costs and changes in overhead are bound to be significant.

Secondly, you may need to build future credit. This is applicable when you have larger-scale financing in mind for the future and can make a start with smaller, short-term loans to build a fair business credit, provided they are repaid on time. A credible credit history always helps to qualify for bigger loans.

Often, purchasing equipment becomes compulsory to improve business performance which again needs financing. Additionally, in equipment financing, the equipment serves as collateral itself for the loan. Moreover, it also needs to be seen first if the equipment is required at all in the first place.

Moreover, loans are often required to purchase additional inventory. This again is a major business expense, and often a loan may have to be taken when there’s a shortage of working capital to buy the same. This is applicable more to seasonal businesses, where large amounts of inventory are required but without the actual cash in hand available.

You may also find a business opportunity that far outweighs your potential debt. It could be the purchase of bulk inventory at a hefty discount, or a retail space available at a throwaway price which is too good to let go. But the cash isn’t available. A loan would certainly help you earn some handsome profits in the long run in such situations.

Finally, when you need to hire fresh talent for your growing business, a loan may be required to get the right people who will not only enhance your business model but keep it innovative and competitive. Taking a loan to get such people makes sense if a clear connection can be established between your hiring decision and increased revenue.

The following are the major types of loans that go into the making of the concept of debt financing for business:

Line-of-credit loan

This is the most useful loan available to smaller business owners. It’s a permanent loan that takes care of business emergencies and sudden working capital shortages. Ideal for inventory purchases and for paying off working capital operating costs and needs for business cycles. This type of loan is not ideal for the purchase of equipment and/or real estate.

This short-term loan enhances any cash that’s available in the business’s checking account to the loan contract’s maximum limit. A particular amount gets transferred to the business’s checking account with the bank for covering checks.

The business, in turn, pays interest on the advanced actual amount, from the time of advance till the time of payment. These loans usually have the lowest interest rates because they are basically low-risk and are given out for one-year periods subject to automatic renewal for an annual fee. For negotiating a credit line, the banker needs to check your latest tax returns, a current financial statement as also a projected cash-flow statement.

Balloon loan

This loan is usually written under a different name, and the full loan amount is released on the contract being signed. However, the interest only is paid off during the loan’s life, with the “balloon” payment of the total due principal on the last day. Lenders also offer balloon loans where both principal and interest are paid off by way of a single “balloon” payment. These loans are ideal for situations when your business needs to wait for a particular date before it receives payment from an external party.

Installment loan

This loan can be paid back in equal monthly installments that cover both the principal and its interest and are ideal for all types of business requirements. You receive the full amount on signing the contract with interest being calculated from that date to the loan’s final day. If an installment is repaid before its final date, no penalty is charged, and the interest is appropriately adjusted. The installment loan’s term is always correlated to its use.

Moreover, these loans may be given out for periods ranging from 1 to 7 years, while loans for renovation and real estate may extend to up to 21 years. Where monthly payments are inappropriate, an installment loan may also be given on a quarterly, half-yearly or annual payment basis.

Secured and unsecured loan

A loan may either be secured or unsecured. When the lender is convinced that the loan will be repaid on time, he may give it on an unsecured basis. This implies that no collateral exists as a guarantee against default. On the other hand, secured loans come only with a collateral but has a lower rate of interest as compared to an unsecured loan. Such loans are generally given for heavy expenses like the purchase of equipment and machinery and also real estate. The lender expects to use the collateral to collect his dues should the borrower default.

Interim loan

In an interim loan, the lender is concerned about the commitment of the borrower to paying off the loan and his identity. These are ideal for making periodic payments to contractors who build new facilities when the buildings’ mortgage is used to repay the loan.

Letter of credit

Given mostly for international business, this document guarantees payment to foreign suppliers from entrepreneurs operating in other countries by substituting the bank’s credit up to a pre-determined amount for a certain time period.

These apart, there are also other types of loans like long and short-term loans; an accounts receivable loan that’s by outstanding accounts; second mortgages or equity loans where real estate stands as collateral for the loan; a guaranteed loan where a 3rd party stands guarantor for repayment; personal loans where the borrower’s personal collateral and signature guarantee repayment; and a commercial loan where a bank offers a standard loan to any small business it thinks is worthwhile.

So identify your need and take your pick. It’s all there for your benefit only.

Jason Smith

Jason is a Senior Author for SBL. He has been working with small business owners like you for the past ten years. He graduated with an MBA and began a career as an independent financial consultant for small businesses in his state. 

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