How Much Of Your Working Capital Should Come From Bank Loans?

There is a lot that goes into planning the finances of a business, no matter how big or small the business may be. The business owner has to be sure that he always has the funds on hand to run his daily operations and create a cash reserve for future projects. It is more than just a simple balancing act; it is the most comprehensive kind of planning any business owner can engage in. If the financial plans of a business are not thought out properly and comprehensive, then it could have long-lasting negative effects on the organization. That is why business owners put so much effort into reading the company books and evaluating economic options.

Working capital is the money that a business uses to meet payroll and make sure that the company has what it needs to operate from day to day. The categories of expenses differ from industry to industry, but the need for working capital is persistent throughout every business in the world. A business owner has to be able to supply the cash his company needs to pay employees and make ongoing business purchases, or he could face the prospects of closing his doors for good. A strong source of working capital is essential to the success of any business.

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What Is Working Capital?

To better understand working capital, let us take a look at an example from the trucking industry. A trucking company agrees to take on an oversized load that must move from the customer's location to a destination several hundred miles away. The trucking company determines that the most efficient route will take the load out on public freeways and other public roads where special permits will be required. In a situation like this, the company must purchase the permit on an as-needed basis. The trucking company owner must accurately estimate the working capital necessary to move the load and still make a profit.

In this example, the working capital would be the cash needed to pay the driver, buy the permits, keep the rig fueled, do any repairs to the rig, pay any tolls, and address any of the costs that go with moving this load from point A to point B. Along with those immediate costs, there are also ongoing costs such as vehicle insurance, the salaries of the maintenance personnel in the depot, the maintenance supplies, and anything else that gets paid on a regular basis. All of these costs require working capital and the ideal solution is to utilize cash flow. But, as we will see, cash flow is not always something a business owner can rely on.

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Not All Working Capital Comes From Cash Flow

In a perfect world, working capital all comes from the company's cash flow. The company issues invoices and then plans on the revenue from those invoices to be in the company bank account on or before the due dates. With the cash reliably installed in the bank account, the company can plan payroll deposits and vendor payments with confidence and keep the staff happy while preserving the company's credit score. Unfortunately, we do not live in a perfect world and past due invoices cause a lot of problems when it comes to company cash flow. When a company tries to make payroll but the aging report indicates a large backlog of past due invoices, then that causes a lot of long-term issues.

Business owners understand the unpredictable nature of their revenue streams, which is why all business owners have a working capital contingency plan. For most companies, the type of contingency plan that is used depends on how much cash is needed. It is not unusual for a small company to have a corporate credit card that it uses to fill in the financial gaps from time to time and keep the company moving along. But for larger issues, many companies turn to bank loans as part of their working capital. Is it a good idea to use bank loans as part of working capital? It all depends on how you use those loans and how well you plan your spending.

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How Much Working Capital Should Be Bank Loans?

There are two issues with bank loans that make them somewhat inconvenient as a permanent solution to slow revenue. First of all, bank loans tend to be limited in how much a bank is willing to supply. Once the bank considers your loan balance to be tapped out, you can no longer utilize loans to fill in the economic holes. The other problem with bank loans is that they take a while to approve. In some cases, you need that working capital immediately and waiting on a bank to approve a loan is not going to work. But that does not mean that bank loans are not good working capital options.

When a company uses working capital, it is usually done based on a schedule that has been in place for a while. Payroll is not a surprise and neither is paying the invoices from primary vendors and suppliers. Bank loans work as excellent enhancements to those times when you see a gap coming and the payroll deposit is due. Those kinds of gaps are usually easy to see weeks in advance and that is when loans can be used to fill in those empty spaces. You do not want a large portion of your working capital to be bank loans because bank loans have a very specific purpose. But when you see a gap coming in your operating expenses, then a bank loan can fill that gap nicely.

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Understand When To Use Loans And When Not To Use Them

There are alternatives to using bank loans for working capital that every business owner should look into. A line of credit works much more efficiently to keep up operating cash than a loan does. Working capital loans tend to have shorter repayment periods than other business loans, which makes these kinds of loans ideal for certain operating situations. If you can negotiate a good rate for a working capital loan with your lender, then it is something that you should take advantage of as it could be more cost effective than utilizing your line of credit.

Working capital loans are there to be used when you need them, but it would be a good idea to reduce your persistent reliance on these funding vehicles when it comes to your long-term funding plans. Investigate ways to improve your cash flow and find other funding options that you can use to keep your company operating at peak efficiency. Work with your bank to have working capital loans as an option when you come up short in meeting your company's ongoing financial needs and make the application process as efficient as possible. Working capital loans can be a small part of your ongoing funding process, but it is always good to limit the amount of debt your company takes on at any given time.