It’s hard to overstate the importance of working capital. A healthy amount of working capital enables a small business owner to meet their daily operational expenses. A lack of working capital, on the other hand, threatens the long-term health of a small business. In this guide, you’ll learn how to get working capital as a small business.
But first, let’s look at why you need working capital:
What is Working Capital?
The working capital formula is your current assets minus your current liabilities. Your current assets are anything that can be turned into cash within the next 12 months, while your current liabilities are your short-term financial obligations that are due within the same period. Your current assets include accounts receivable, inventory, and bank accounts. A few examples of current liabilities are accounts payable, interest payable, and taxes owed within the next year.
If your current assets are greater than your current liabilities, you have positive working capital. If your current liabilities exceed your current assets, you have negative working capital.
How Much Working Capital Do You Need?
So, are you okay as long as your current assets equal your current liabilities? Not exactly.
You want your current assets to be significantly higher than your current liabilities so that you have enough cash to cover any business needs.
Here’s a possible scenario: your working capital is equivalent to two weeks of business expenses, but two of your biggest buyers are three months late in paying for their orders. The combined amount is equal to one month of business expenses, and you don’t have enough cash to cover your operating expenses.
Or let’s say that an expensive piece of machinery breaks and you need to replace it immediately… but you don’t have enough cash on hand to buy the new unit.
It’s clear that you need to have positive working capital, but exactly how much do you need?
The ideal working capital ratio (current assets / current liabilities) is considered to be between 1.5 and 2. But that number can be a little higher or lower depending on your type of business and operating cycle.
Type of Business
Your working capital needs will be higher if your business has some or all of these characteristics: a lot of physical inventory, seasonal, and high business growth. If your business has low physical inventory, steady revenue, and has matured, your working capital needs will be on the lower end.
Does your business bill customers upfront or after services have been rendered? If it’s the latter, you will need more working capital. The amount of time it takes for your business to create and sell a product also impacts your ideal working capital ratio (the longer it takes, the more working capital you need).
How Do You Get Working Capital?
So, you’ve determined that your net working capital is not sufficient to meet your business needs, but you’re not sure how to get working capital as a small business.
In many cases, small business owners get working capital through term loans, SBA loans, or personal savings. But there are some issues with these funding options.
To qualify for a term loan, you need to have a high credit score and a profitable history. You may need to borrow a minimum of $25,000, an amount of money that exceeds the working capital needs of some small business owners. You also face the possibility of a slow approval process, a deal-breaker if you need more working capital immediately.
Small Business Administration (SBA) loans are attractive for small business owners, but it is difficult to qualify for one of these small business loans. You not only need a high credit rating and profitable history, but you also need to have exhausted your financing options. It’s challenging to meet all of those conditions.
It may seem tempting to use personal savings to meet your short-term financial obligations, but it is risky to mix your personal assets with your business assets. What happens if your business takes a turn for the worse? Or if you eventually need to take the cash out to meet your personal needs – but it isn’t available?
Here are seven alternative small business financing options that can provide working capital for a small business owner:
1. Merchant Cash Advance
A merchant cash advance (MCA) gives a small business owner upfront cash in exchange for a piece of future sales. This financing option was originally designed for businesses that relied heavily on credit card and debit card sales, but now it is available to small business owners who rely on other payment methods. An MCA can be structured based on a percentage of your actual sales or an estimate of your future sales.
You can qualify for a merchant cash advance with a low credit score and without a long track record, but MCAs come with high annual percentage rates (APRs) – sometimes in the triple-digits. This means that you should only consider a merchant cash advance to meet a short-term lack of working capital.
2. Invoice Factoring
Do you have a large number of accounts receivable on your balance sheet? If so, you may have a strong working capital position – but you may be unable to meet your financial obligations. A possible solution is invoice factoring, a business financing option that lets you sell your accounts receivable to a factoring company at a discount for a lump sum of cash. You would lose out on some of your revenue, but at the same time, the immediate cash could be a game-changer for your small business.
The discount rate can be anywhere from 1% to 5%, depending on the amount, the creditworthiness of your customer, and the factoring company. You should shop around to find the best terms.
3. Business Credit Cards
A business credit card can be an excellent way to meet your working capital needs if you have short-term working capital needs and you can find a credit card with a low APR.
For example, you have a seasonal business and you need to purchase more inventory for the busiest three months of the year. You are able to find a credit card with a 0% APR introductory period of one year, and you are confident that you will be able to pay it back in full over the next six months. In this example, it would be smart to purchase the inventory with a business credit card.
But what if you need to increase your working capital for an indefinite period of time and the lowest APR you can find is 14%? If this is the case, you could end up paying a large amount of money in interest – with no end in sight.
4. Bank Overdraft Facility
As a small business owner, you probably try to avoid overdrafts. So, you may be surprised to learn that you can arrange a bank overdraft facility with your bank, allowing you to draw beyond the amount of money that you have on deposit without incurring any penalties. With this arrangement, you simply pay interest on the overdraft amount, and you don’t have to worry about your standing with your bank.
This is a good way to meet occasional working capital shortfalls, but you shouldn’t use this to take care of long-term working capital needs, as the interest payments can really add up over a long period of time.
5. Peer-to-Peer Loans
Peer-to-peer lending allows small business owners to connect with individual investors, taking away the need for a financial institution to act as the middleman. The modern peer-to-peer lending system has been around for less than 20 years, so it is a relatively new financing option.
A borrower who is having trouble getting other types of financing due to a low credit score or short credit history may be able to get approved through a peer-to-peer marketplace. The appeal for lenders is that they can generate higher interest earnings relative to a checking or savings account.
The interest rate on a peer-to-peer loan can vary dramatically – it depends on the creditworthiness of the borrower and the platform. But in some cases, you can secure attractive terms.
6. Equity-Based Crowdfunding
Let’s say you have a startup that seems risky; it has a good chance of being extremely successful, but there’s also a good chance that it won’t take off. You might struggle to get loans at a reasonable interest rate because there is a decent possibility that the value can go to zero… but the lender can only collect the interest on the loan.
You may want to consider equity crowdfunding in this situation as the upside of the business idea could allow you to get financing without giving up a big chunk of your business. If you go with this option, carefully craft and review the terms of the agreement as this isn’t a standard funding option.
7. Business Line of Credit
A business line of credit is a flexible financing option – you can secure access to an amount of money, but you only have to pay interest on what you borrow. You typically won’t be asked to commit to how you will use the money, which is ideal for someone with possible working capital needs in the future.
Let’s say you have a sudden spike in demand, but you have traditionally offered your customers net 30 payment terms. You don’t have the cash flow to cover the costs of rendering the services. If you have a line of credit, you can immediately borrow the amount that you need, and pay it back after your day-to-day operations have normalized.
A business line of credit is an excellent financing option, but there is typically a variable, not a fixed APR. This means that you could be stuck paying a higher interest rate than you originally anticipated.
The Bottom Line
Working capital is the lifeblood of a business, so getting working capital financing is crucial if you do not have a healthy working capital ratio. As a small business owner, it isn’t always easy to get a working capital loan – particularly if you have a new small business. That’s why you need to consider the alternative financing options mentioned in this guide.
Biz2Credit can help you meet your working capital needs, with a simple and straightforward application process and approval process that allows you to get cash in as little as 72 hours.