Disadvantages of Using Debt Financing for Working Capital

All long-term, successful business owners understand the need for good cash flow to ensure the health and longevity of the company. Positive operational cash flow arises from converting accounts receivables to actual receipts faster than paying out cash to run the business. Working capital is the short- and medium-term cash that funds operations. Debt financing is one way to fund working capital.

Debt can weigh down your company when used for working capital.

Working Capital

Working capital provides the critical funding needed to operate a company on a daily basis. It is the net of current assets minus current liabilities. Current, or short-term, assets include accounts receivable, inventory, prepaids and cash. Working capital indicates how well-positioned a company is to meet its obligations in the near term. Working capital financing covers the gap between the cash that flows in from operations and the cash that flows out.

Debt Financing – Short-Term

A reliance on short-term debt to cover working capital often signifies poor planning. The need for working capital is constant, ongoing and not limited to the near term. Short-term debt’s interest rates typically vary, leading to fluctuating, somewhat unpredictable expenses. Each new loan or renewal typically carries an origination fee. Short-term debt reduces liquidity, because the principal must be repaid quickly. If the company cannot repay the principal with another source, then the company is in danger of going bankrupt.

Specific Short-Term Financing Option Disadvantages

Accounts receivables require more efforts to track and manage, so accounts-receivable financing entities typically charge higher interest and fees. High interest rates and fees decrease operational cash and the earnings the working capital supports. If a lender believes your business or your industry outlook is degrading, it can pull your credit line. A factoring firm engages directly with your customer, so you could lose control of your customer relationship. With inventory financing the lender may take possession of the inventory until the loan is repaid.

Debt Financing – Long Term

Long-term debt financing of working capital may have a less adverse effect on operational cash flow than short-term, but it still has disadvantages. Long-term debt financing can increase financial leverage and financial risk. It can reduce liquidity, especially if the loan has balloon payments which come due during an operational low point. Long-term debt often has higher interest rates and fees due to the longer term and greater complexity and may come with prepayment penalties. Some long-term debt may have restrictive covenants which make it difficult to use the proceeds as you want.

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