Working capital loan

What it means

A working capital loan finances the cycle rather than assets: stock, receivables and wages in the gap between paying suppliers and collecting from customers. It is repaid out of turnover, which is why it is short-dated and usually takes the form of an overdraft or a revolving facility.

It differs from an investment loan in purpose and in repayment logic: an investment loan is repaid from the return on the asset over years, a working capital line is meant to come back to zero within the year. If the balance on the overdraft never falls, this is no longer working capital finance but hidden long-term debt.

A working capital loan need not take the form of an open line. Banks also offer a purpose loan for a specific contract or season, drawn against invoices and repaid from the money collected on that same contract. The alternative without a loan is factoring, which releases cash straight from issued invoices.

How it works in practice

The bank looks at working capital, stock and receivable days and seasonality; the limit follows turnover and the money genuinely tied up in the cycle. The application carries the financial statements, a trial balance, the aged ledgers and confirmations from the tax office and the Social Insurance Agency that nothing is in arrears.

The contract usually carries covenants: debt to EBITDA, an equity ratio, a ban on further security and a duty to deliver figures on agreed dates. The line is normally renewed once a year, so the company’s creditworthiness is tested again each time.

While the loan runs, the bank asks for interim statements, often quarterly. We therefore align the monthly close with those dates and send the bank the trial balance and an ageing of receivables in the form the contract requires, so nothing has to be dug out when the line comes up for renewal.

What to watch out for

The common and expensive mistake is paying for a machine or a fit-out from the operating line. The money stays inside the asset, the line never returns to zero, and at the annual review the bank cuts the limit or declines to renew: the company must repay in one go a sum that is no longer circulating.

Security is the second risk. A working capital loan is often backed by a charge over receivables or stock, plus a guarantee from the managing director or a shareholder, such as a blank promissory note. When the business struggles, the bank then reaches not only for the company’s assets but for the private assets of whoever signed the guarantee.