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Deciding on the best approach to working capital funding requires taking a realistic look at the current status of the business, including its credit rating and the potential for generating enough revenue to repay the funding source in a timely manner. There are three basic ways to manage this type of funding successfully, with each method offering its own advantages and liabilities. Those three approaches are the establishment of a line of credit, working with a factoring company, or obtaining a working capital loan.
A working capital line of credit is easily one of the most versatile options for working capital funding. In this scenario, the lender extends a line of credit that the business can draw upon when and as needed. Interest is assessed on the current amount of the credit line in active use rather than the entire credit limit. This creates a situation in which a business could theoretically utilize the line of credit at the beginning of a billing period to settle currently due obligations, then use its revenue stream to repay the amount borrowed on the line of credit before the end of that same period. Doing so means little to no interest is due, allowing the business to avoid the creation of an additional expense.
Another effective approach to working capital funding is to obtain a working capital loan. With this option, the business obtains the full amount of the loan at one time. Interest charges begin to accrue at the time the loan is extended. Should the business not require immediate use of the funds as working capital, they may be placed in some sort of interest-bearing account, allowing the unused balance to earn some amount of interest and at least partially offset the interest that is charged on the loan. Care should be taken to make sure that the monthly installment payments can be met without fail, preventing the application of late fees and penalties.
Working capital factoring is another means of obtaining working capital funding. With this option, the company sells the accounts receivable for the latest billing period to a lender that is known as a factoring company. The lender evaluates the invoices, the issues the debtor a payment amounting to most of the face value of those invoices. Typically, this advance payment is in the range of eighty to eighty-five percent. Customers remit payment directly to the factoring company, which applies those receipts to the debtor’s account. Once the batch of purchased invoices are mostly paid, the lender issues a second payment to the debtor that accounts for most of the remainder of the collected revenue from those invoices, less a percentage of three to five percent for providing the funding.
All three approaches to working capital funding have worked for companies of different sizes. While each method has its advantages, there are also potential drawbacks. An inability to repay the balance borrowed on a line of credit or a loan can damage the company’s credit rating, making it hard to obtain funding in the future. With the factoring process, the lender takes over the collection process and may use methods that have a negative impact on customer relations. This can result in losing clients, which decreases the total revenue stream over the long-term.