Your business needs access to cash. Most every business does. But when is a Working Capital Line of Credit the right choice? What are your alternatives? Our Director of Commercial Loan Services, Ryan Reffitt, offers his insight on the top questions asked when it comes to business cash flow needs.
What is a Working Capital LOC (Line of Credit)?
Also called a Business Line of Credit, a Working Capital Line of Credit is similar to a credit card but allows you, the business owner, to quickly tap into funds for day-to-day operational needs. It often offers a lower interest rate than a credit card and is generally secured by short-term assets (such as accounts receivable or inventory). You may need to provide your accounts receivable ‘aging schedule’ on a monthly basis, detailing all customers that you owe money and how long that receivable has been outstanding. In general, your business line of credit will permit you to borrow up to 80% of the outstanding accounts that are less than 90 days old. For example, if you have $100k in outstanding receivables of less than 90 days, you may borrow up to $80k or the maximum limit of your line of credit. The typical term is 12 months, and you may need to renew or pay off the loan at the time it matures.
Businesses seek a Working Capital Line of Credit for flexible access to cash.
What are the advantages and disadvantages of a Working Capital Line of Credit?
On the plus side, a working capital line is extremely flexible enabling a business to draw on cash as needed. It can be used for a variety of purposes. And, it is almost always less expensive than using a business credit card and offers higher credit limits. It is critical for most any business to have the access to cash when they need it.
However, lenders prefer the line to be used for day-to-day operations and not long-term capital purchases, so there are certain restrictions. Lenders may also require the line to be paid down to a $0 balance for a 30-day period known as a ‘rest’ period. Line of Credits usually mature in 12 months, and the business can choose to renew its Line of Credit at that time.
A Working Capital Line of Credit is often less expensive than other forms of credit offering flexible draws for multiple needs. The borrower will need to pay off the line (usually for 30 days in a 12-month period), and at the time of maturity, reapply for another Business Line of Credit.
Why is it important to have access to cash or working capital? Is it a reason some small businesses falter or fail?
Yes, because cash is king. Most people believe sales are most important, and they are important, but cash is what pays your employees, suppliers, utility bills, etc. Depending on the industry, it can take 30 to 180 days for sales to convert to cash. Here is where a Working Capital Line of Credit comes into play.
Case-in-point: Let’s say you make a sale of $100k to a customer. You offer 30 days before you require the customer to pay you. However, you still have several daily expenses to meet (i.e. payroll, utilities, and taxes). With most Working Capital Line of Credits, you can borrow up to $80k (or 80% of accounts receivable under 90 days past due) to help with your cash flow. When the receivable comes in from your customer, you can pay the Line of Credit down, and the cycle continues.
In the example above, if a business didn’t have a Working Capital Line of Credit or enough cash on hand, its employees, bills, and suppliers wouldn’t get paid. A shortage of working capital prevents inventory from being purchased with the potential for missed opportunities, such as taking advantage of supplier discounts.
A Working Capital Line of Credit keeps your cash flow strong and can help meet daily expenses.
How is a Working Capital Line of Credit different from other types of Line of Credits?
A Working Capital Line of Credit is the most common and flexible business credit line. As a business owner, you might also consider a Capital Expenditure or CAPEX Line of Credit, which has a pre-approved limit used to purchase equipment over time or a ‘draw period.’ Once the draw period has expired, the loan automatically terms out (or amortizes) for a predetermined period such as 3, 5 or 7 years.
A CAPEX Line of Credit is a specific credit line usually reserved for planned equipment purchases over a smaller time period (i.e. 1 to 2 years).
When is a CAPEX Line of Credit the better alternative?
This option is best for a business that regularly purchases equipment throughout the year or has planned equipment purchases for the next year or two. Rather than having each purchase approved by the financial institution with a separate closing, the CAPEX line allows you to purchase a certain dollar amount of equipment. It is usually within a 12-month period offering an amortization schedule and term similar to a normal equipment purchase. Also, you, as the business, will typically need to provide at least 20% of the purchase in the form of a down payment.
A CAPEX Line of Credit is a good fit for businesses that require frequent or planned equipment purchases over a short period of time.
How should a business compare products and terms?
Always look at the whole picture: compare rates, fees, terms and the cash advance rates you’re allowed, especially for a Working Capital Line of Credit. For example, can you tap into 70% or 80% of your accounts receivable? Also, compare the added value the lender provides. Is the lender just a seller of the commodity of credit? Or do they ask you questions about your business, offer insight, and provide a consultative perspective to your company? Establishing a long-term relationship with your financial institution, and ensuring they have your best interests at heart has value.
Consider the relationship you have with your lender. Remember trust between you and your financial institution will always positively impact your business.
What are valid reasons to establish a Working Capital Line of Credit?
There is a variety of reasons why a business would approach us for a Working Capital Line of Credit. Most are legitimate cash needs that show a healthy company that is looking to grow. For example, the company is taking on a new customer base or has a large pending order, but just needs the extra bump in cash to make it happen. Sometimes seasonality impacts a business, for example, a parking lot striping company in Michigan will perform the majority of its work between April and October. In March, it increases its paint inventory but won’t get paid for the first job until June. In the meantime, the company still needs to pay employees and other bills. These are excellent reasons to tap into a Business Line of Credit.
Seasonal businesses may need to use Working Capital Lines of Credit more often.
When is the need for cash a warning sign?
Sometimes, a request for a working capital line can be a warning sign of an operational issue, poor business management, and in rare cases, employee embezzlement or fraud. For instance, a company loses a major customer but doesn’t cut overhead to compensate; a company is having trouble managing collections; or, accounts receivable has stretched from 30 to 60 days.
As a lender, these are patterns we look for when approached for a Business Line of Credit. Our goal is to ensure the company’s management team has recognized its cash flow bottlenecks and a plan for correcting any root problems. At ECCU, we also help our members to realize that a Working Capital Line of Credit cannot correct poor management. If the cause of poor cash flow isn’t corrected, the line of credit will keep growing and eventually the company could file bankruptcy. It’s critical for any business owner to have a close relationship with their lender and to take part in frank and honest discussions about operational and financial issues, frequently.
If a borrower is using working capital for perpetual cash flow problems, it might be a warning sign of a more serious, underlying issue.
Conclusion: Cash is king.
Without thinking through your cash flow, you could set your business up for failure. When making a sale and allowing customers 30, 60 or 90 days to pay that is a use of YOUR cash. Yes, it is booked on the income statement as a sale, but you are ‘floating’ that expense – using your cash for the sale until you receive payment. That’s why it is imperative to understand and manage cash flow cycles.
At ECCU, we have our business members’ best interests in mind. We look at the whole relationship and advise our members on strategies best for their business. Contact us if you have questions about a business loan or any of our business services. We’re ready to help. Or, call me personally at 269.544.3478.