What is working capital?
Working capital, generally speaking, is the money a small business uses to deal with daily operational expenses like utilities, supplies, payroll, inventory, or rent. It keeps your business “working” (get it?) by paying for daily operations.
As a financial metric, working capital (also known as “net” working capital) is the difference between a small business’s current assets like cash, accounts receivable, and inventories and its current liabilities like accounts payable.
- Working Capital = Current Assets – Current Liabilities
For example, if your small business has $100,000 of cash, $200,000 of accounts receivable, $50,000 of current inventory, and $150,000 in accounts payable (basically debt), your business has a total of $200,000 in working capital.
Another common financial metric relating to working capital is your working capital ratio. This is your current assets divided by your current liabilities.
- Working Capital Ratio = Current Assets / Current Liabilities
Using our example, our hypothetical small business has a working capital ratio of 2.33. Experts and analysts usually suggest that a business should aim to have a working capital ratio between 1.2 and 2. Too small and you’re in danger of running out of cash. Too big and your business isn’t using its assets to the best of its ability, thus hampering potential growth by hoarding cash and other assets. Our hypothetical business is in a healthy position and could afford to spend a bit of its cash to invest and spur growth in the business.
What are working capital loans and why might you need one?
Working capital loans are a type of small business loan that are specifically designed to boost a small business’s working capital levels.
To understand why they can be useful, we need to explore the concept of cash flow management. Lots of small business owners, especially those with less experience, think that if they manage their finances well enough, they should never need extra cash, and if they do it’s because they’ve made a mistake and lost money. This typically leads to small business owners holding onto too much cash (or cash equivalents) in reserve that can be relied on in case of emergency. In one way, they’re smart to think this way: according to research done by the U.S. Bank and cited on the SCORE/Counselors to America’s Small Business, 82% of small businesses fail due to poor cash flow management.
While this is a good practice, it can be harmful to your business if it goes too far. Every dollar that you hold in reserve is a dollar that isn’t being used to grow revenue, invest in new technology, or otherwise reinvest back into the business. So, it’s crucial that you maintain a healthy balance of reserving cash and reinvesting revenues/profits. Additionally, business opportunities are never served on a silver platter and sometimes you have to shell out a lot of cash to take advantage of a time-sensitive business opportunity like spending a lot to fulfill a huge purchase order. This can place a lot of, usually temporary, pressure on your business’s cash flow.
This is where working capital loans come in. They are an excellent business financing tool that small business owners can use to get quick influxes of liquidity when their business needs it to cover business operations and daily expenses. They’re a much more affordable way to get quick cash compared to business credit cards, which typically come with extremely high interest rates.
What are the different types of working capital loans?
Biz2Credit has an excellent, in-depth guide on the different kinds of working capital loans available to small business owners. I’ll summarize some of the more popular ones below but be sure to check out the guide to get a full understanding of what is available to you.
Short Term Loans
Short term loans are generally a more traditional loan obtained through a traditional financial institution like a bank or credit union. They’re very different from a business line of credit in that they will typically have a fixed interest rate and the loan amount will be disbursed in full all at once.
These loans also often require that you post collateral and can come with higher interest rates due to their short-term nature. The stronger your credit score and historic revenues, the less collateral you’ll have to post, and you’ll likely be able to get more affordable interest rates. Borrowers with extremely strong applications might even be able to get an unsecured loan, posting no collateral at all.
Invoice factoring is a financing option that allows you to sell all or a portion of accounts receivable (unpaid invoices) to a third party, almost always at a discount. This is a great way to get immediate cash on your balance of outstanding invoices, with the obvious downside of losing out on some of the revenue.
Invoice factoring can be very expensive, with third parties demanding relatively high discounts. Make sure you shop around with many lenders to find the best rates. Online lenders often have better rates than traditional financial institutions.
Quick Tip: Invoice factoring is very different from “invoice financing”. Invoice financing involves using unpaid invoices as collateral to obtain a more conventional loan.
Merchant Cash Advance
A merchant cash advance is a commonly used financial instrument for businesses that accept credit card payments. Basically, your credit card processor, or another financing company acting as a third-party, will “advance” certain amounts of cash based on your business’s historic dollar volume of credit card sales. The advance is then paid back to the lender directly as a portion of future credit card sales.
Small Business Administration (SBA) Loans
Many small business owners don’t realize that the SBA guarantees smaller loans for small to medium-sized businesses.
Check out this guide from Biz2Credit to learn more generally about SBA loans.
Specifically, the SBA 7(a) loan program is well suited for smaller loans that can be used for working capital needs. The 7(a) program can provide loans anywhere between $5,000 and $5 million.
The SBA doesn’t loan to businesses directly but rather works through approved lenders to guarantee the loans that are given. You’ll need strong credit history and there is additional paperwork that needs to be completed. The upside is that these loans typically have lower interest rates and better repayment terms.
What is needed to acquire working capital loans for small businesses?
As we discussed, working capital loans come in all shapes and sizes, with differing eligibility requirements, application processes, and associated interest rates. Here’s a great summary table from Merchant Maverick.
Generally, though, lenders look for the following things:
- A Strong Credit Score: Credit scores are an easy way for a lender to understand how good you are at handling loans and other forms of credit. The stronger your business and/or personal credit score, the easier it will be to get both a loan at all and a better rate.
- Revenue History: Lenders will look at your financials to determine your history of revenues. Particularly, they’ll look for consistent revenues over a long period of time. This tells them that your business is healthy and can afford to make monthly payments on your working capital loan.
Time in Business: Lenders typically want a business that has been around for a while. This means it’s harder, but not impossible, for new businesses to secure working capital loans. New businesses will typically face higher rates, might have stricter collateral requirements, may need to make personal guarantees, and will face a more stringent evaluation during the approval process.