How working capital loans work

Working capital lines of credit are designed for short-term operational needs, so they’re secured by short-term assets—typically your accounts receivable and inventory. There are two common types, with differences in structure and the underwriting criteria borrowers must meet: 

• Cash flow: Lenders extend traditional working capital lines of credit based primarily on your business’s ability to generate enough cash flow to repay the amount borrowed with the support of short-term assets. This approach works well for companies with strong recurring revenue. 
• Asset-based: With an asset-based loan (ABL), your borrowing capacity fluctuates with the value of your collateral. Lenders conduct in-depth appraisals and require regular reporting on those assets. ABLs work well for asset-rich, working capital-intensive companies or seasonal businesses with uneven cash flow. “ABLs can be very flexible, maximizing working capital availability when it’s most needed, such as when a retailer ramps up inventory ahead of the holiday season,” said Kelly O’Malley, senior originator for ABL at J.P. Morgan. 

 With both types of credit lines, lenders evaluate cash flow and assets before determining whether to offer a line of credit. Even with traditional working capital lines based on cash flow, your borrowing capacity will often depend partly on the value of assets securing the loan—your borrowing base. 

With both cash flow and asset-based working capital lines, interest is typically variable and charged only on what you borrow. You may have the option to lock in a set interest rate for 30 to 90 days, providing rate certainty if you’re planning to keep your credit line drawn rather than paying it down daily.

Benefits of working capital loans—even if your business has cash reserves

Working capital loans may seem unnecessary if your company has positive cash flow and healthy reserves. But there are clear advantages to establishing a line of credit before you need it urgently. 

“The last thing you want to do is try to put a working capital line in place when it’s an emergency and before even having a conversation with your banker about what you do, how you pay and get paid, your cashflow cycles, and needs,” Ribaudo said. 

In addition to providing a backstop when a company needs extra working capital, a working capital line of credit can help businesses: 

• Scale borrowing capacity quickly: When you need extra working capital unexpectedly—to make an acquisition or pay new tariffs, for example—it’s easier to expand an existing line of credit than start from scratch. “You’ve built a relationship with the bank, and they already understand your business,” said Matt Brennan, lead credit officer at J.P. Morgan. “It’s not a scramble when the company needs $1 million next week.”  
• Build vendor relationships: Vendors often feel more comfortable working with you when you maintain a line of credit. “It’s a way to provide comfort that a buyer of a product has access to working capital if they need it to make payments, quicken payments or even support larger orders in the future as they grow,” Ribaudo said. 
• Access early payment discounts: When vendors offers discounts for paying invoices early, you can use a line of credit to capture those savings while preserving your working capital—often the discount rate exceeds the interest cost, creating a net financial benefit.

Choosing the right working capital loan for your business

Working capital loans are flexible and can be customized to your business’s needs. A lender that knows your industry and business can help you find the ideal option, as well as solutions for managing line of credit payments. For example, sweep accounts can help minimize interest payments by automatically using excess cash to pay down your line of credit. 

Lenders also help you determine your optimal working capital borrowing capacity. 

“Right-size doesn’t mean outsize,” Ribaudo said. Both cash flow and asset-based working capital credit lines can be adjusted during the loan’s term if your needs change. 

“It should be big enough to support the company, with a bit of cushion. If a transformational event happens, we can discuss increasing it or moving from a cash flow line to an ABL, or vice versa,” Brennan said. “We work with the company to find the right fit.”