The Definitive Guide to Working Capital for Business Owners
March 1, 2021 | Last Updated on: February 15, 2023
March 1, 2021 | Last Updated on: February 15, 2023
As of May 28, 2021, the Paycheck Protection Program has run out of funding. You can learn more about the PPP with our COVID-19 resource hub.
A small business owner always needs to have enough cash on hand to cover short-term expenses. But because cash flow often cannot be counted on as a consistent source of reassurance from month to month, sometimes the entrepreneur must resort to other teams to ensure that there is always enough working capital to keep the company functioning unabated.
Inventory, payments on short-term debt and operating expenses–the day-to-day expenditures that keep the business going–all comprise working capital. Maintaining smooth, uninterrupted operation of the business so that it can meet all of its financial obligations is dependent upon the ongoing presence of working capital.
During a crisis, such as the recent coronavirus pandemic, a small business needs to remain solvent and financially viable so that when the crisis passes, the company can come out the other side ready to resume normal operations without any interruptions in the ability to pay its bills.
There are more than 30 million small businesses across the United States. Because they’re small, they are vulnerable. Some of them are doomed not to succeed even in the best of times, and many more become vulnerable during more challenging times–when the stock market plummets or an unforeseen cataclysm like COVID-19 occurs. Working capital financing can be the lifeblood that keeps a company afloat during tough times, or whenever cash flow necessitates accelerating.
A government agency that provides support for entrepreneurs, the United States Small Business Administration (SBA) backs small business loans issued through their lending partners to help lower financing rates for business owners. The SBA also can help entrepreneurs to qualify for loans for working capital. The SBA has a loan program with the purpose of making access to capital more attainable to business owners. Featuring low down payments and interest rates that are below market rate, the SBA 504 Loan Program allows small and medium-sized businesses to invest in their facilities and expand their reach, giving them more stake in their community. The SBA 504 program was developed with the intent of aiding small businesses in the creation of wealth.
Working capital loans secured through the SBA usually mean a larger selection of loan sizes, repayment terms that are lengthier and interest rates that are not exorbitant. Other means of short-term funding usually don’t offer annual percentage rates as low as SBA loans.
SBA loans require a lot of paperwork, with a considerable amount of applications to fill out. Approval also will depend heavily on the applicant’s business history and credit score. But if you are willing to deal with all the red tape that goes with applying for an SBA loan, the upside is markedly lower financing rates and generous lengths of time to repay the loan than is the case with other loan options.
The length of an SBA loan can range from between five and 25 years. Although loans backed by the SBA give small business owners more access to financing, those loans still are competitive.
According to 2016 data from the Small Business Association, SBA loans are most frequently approved for the following types of businesses:
Restaurants (full and limited service)
Gas stations (with convenience stores)
When money is required for a quick infusion of cash without the burden of exorbitant interest rates, a short-term loan might be just the right kind of financing for a small business owner’s working capital needs. Short-term small business loans usually range from three to 12 months, and they are more likely to require collateral than loans of longer terms, but for a borrower who is relatively certain that he or she will be able to pay back the loan on time, a short-term loan can save businesses money. Short-term loans are widely available, but are targeted toward consumers who are good candidates to pay the loan off.
Although the business credit requirements are not as strict for short-term loans as they are for regular term loans, the frequent payment schedule may be burdensome for someone in a new business without a lot of cash flow at that moment. With fewer requirements than longer-term loans, short-term loans from online lenders may be easier to get approval than some other types of loans.
Choosing to apply for a short-term loan comes with the expectation that you might have to repay it over just a couple of weeks. If you have an installment loan, you have up to six months to pay it off. A short-term loan application is completed online and normally takes a matter of minutes to be approved.
Rapid processing is one of the main attractions of a short-term online loan. Sometimes approval could even come the same day the application is placed. In addition to fast approval, other advantages of short-term online loans for working capital include paying less interest, the chance to improve a bad credit rating, and flexibility.
A method of securing working capital that is a little different than applying for a loan, invoice factoring is the process of selling invoices at a discounted rate to a factoring company and receiving in return a lump sum of cash that can be used as working capital.
After assessing the risk of financing the business owner’s invoice, the factoring company collects payments from the business’ customers over a span of between one and three months. If a company sells something to a customer, but that customer cannot pay off the invoice right away, there’s a gap of time that could create a shortfall for the business owner. The lump sum that the business would receive by undertaking the process of invoice factoring would cover the shortfall and solve the problem of cash on hand.
The business will sell the invoice to the factoring company at a 3 percent discount, to account for the factoring fee. This method of securing working capital enables a business to work around the obstacle of a slow-paying customer. Some factoring companies will supply the cash needed for working capital in as little as 24 hours.
Some of the drawbacks to invoice financing for business funding include surrendering control, taking on the potential stigma associated with factoring (which some observers could interpret as a sign that one’s business is struggling), and the cost (when factoring companies manage the process of collections and the control of credit, it is more costly and the business’ profit margin takes a hit as a result).
With apologies to Ringo Starr, sometimes a small business might want to consider raising working capital with a little help from its friends. Crowdfunding is a way to do just that. Tapping into the combined resources and contributions of friends, customers, family and possibly individual investors by using social media and online platforms set up for this specific purpose is called crowdfunding.
The process of crowdfunding entails collecting small amounts of capital from a large base of contributors, accessing a sizable potential pool of resources. Crowdfunding is open to anyone. The business owner who seeks to raise capital through crowdfunding is essentially turning over the process of an application to a large group of people, rather than depending on the decision of an individual lender. Crowdfunding sites generate revenue from a percentage of the funds raised.
The advantages of a crowdfunding approach to raising working capital include its broad reach, the ability to present one’s business in a positive light to potential investors, the attention to one’s business derived from public relations and marketing on a crowdfunding platform and efficiency. Crowdfunding helps a business to streamline its fundraising efforts with a single profile that is comprehensive and into which the entrepreneur can funnel all prospects and potential investors. Presenting one’s business to a large audience at one time eliminates the inefficiencies associated with printing documents, putting together binders manually entering every update.
Crowdfunding can be based on donations, rewards or equity. A funding effort that is based on donations comes with the understanding that there is no financial reward to the donor to a crowdfunding campaign. A campaign based on rewards would give something back to the contributor, such as a product or a service provided by the business that is seeking the funding. Equity-based funding campaigns invite contributors to become part-owners of the business by exchanging capital for equity shares. As equity owners, the company’s contributors get back a financial return on their investment and also receive a share of the profits in the form of a dividend or distribution.
Peer-to-peer lenders diverge from traditional lending sources in that they work with individual or corporate investors who provide funding for business and consumer loans. Peer to peer personal loans are offered directly to individuals without the intermediation of a bank or traditional financial institution. Online lending platforms fund borrowers via institutional lending partners. Also referred to as marketplace lending, peer-to-peer (p2p) lending is an increasingly popular alternative to traditional lending. Borrowers and lenders can both benefit from this more-direct lending system.
In p2p lending, one party lends money to a business, with the promise of receiving a sizable return for doing so. When a business seeks a p2p loan, it accesses a website, requests a loan, and then investors are permitted to fund the loan and also share in the interest payments.
Just as a conventional lending institution would do, a p2p platform will investigate the finances of the small business owner who is seeking a loan. Investors will want to know the borrower’s credit score, his history of paying bills on time and his or her debt-to-income ratio before deciding whether the borrower’s financial statements are in good enough order to merit funding the loan request. Then the loan–which sits on the platform for two weeks (or less) awaiting investors–is assigned a score based on its level of risk. Investors in a p2p loan can offer to pay as little as $25 of the loan. One p2p investor could conceivably choose to bankroll an entire loan, as well. Every time a payment is made, the investor receives his/her of the interest payment and the principal payment back in his account.
The amount of cash on hand used to keep a small business operating is considered working capital. It does not include liabilities and obligations. The amount of working capital a company requires varies in part depending on the size of the company. In general, the larger the business, the more likely it is able to operate with negative capital. A small business really needs to have a positive amount of working capital at all times.
A business’ current assets consist of all that a company owns that can be converted into cash within the next year; current liabilities are the costs and expenses the business incurs within 12 months. Businesses with physical inventory require a lot of working capital to operate without a hitch. Retail and wholesale businesses, and manufacturers, all would fall into this category. Manufacturers need to keep on buying raw materials to make inventory. Retailers and wholesalers must buy manufactured inventory for sale to distributors or consumers.
Seasonal business, such as retail operations that have a “busy season” and a slow time of year, also need a lot of working capital. Conversely, a company that provides a service instead of physical merchandise do not require as much working capital. More established businesses that are no longer in an early growth stage also might not be in as much need of a large amount of working capital.
A company should aim to be able to use revenue from its sales in order to pay short-term expenses. A business that needs a longer amount of time to produce and market a product will need more working capital in order to meet its expenses during the interim. A company that bills its customers instead of taking up-front payment also falls into the category of needing more working capital.
A poor credit rating is not necessarily always the result of irresponsible actions. When a small business suffers a hit to its credit rating, but still needs an infusion of working capital, there are a few solutions to consider.
A business that is on amicable terms with its vendors could request an extra amount of time to pay its debts to those vendors. It is obviously more advisable to pay vendors early, which helps establish strong credit, but a solid relationship might lead to vendors being more understanding and more trusting about the idea of allowing the business an extension. A company in need of cash on hand could also ask vendors if it’s possible to pay off bills in installments.
Asking someone outside the business realm for a loan is another possible solution to covering short-term expenses without a lot of cash on hand. But borrowing money from family or friends is obviously a situation fraught with its own potential for negative consequences.
There are lending options that are less demanding of strong credit. In addition to short-term online loans and invoice factoring, both discussed above, three other financing solutions for a borrower with weak credit are lines of credit, micro-lending services and merchant cash advances.
When a lender provides pre-approved funding with a maximum credit limit, that is known as a business line of credit. If the borrower is approved for this line of credit, funds can be accessed whenever they are needed until the established credit limit has been reached.
Because the borrower is only paying interest on the amount that he or she withdraws, a business line of credit can be advantageous for business owners who are uncertain of the amount of funding they will actually require, or when they might need it.
The drawback to a business line of credit is that the loan will be at a rate that might be considerably higher than other types of loans. How costly that actually would be is heavily dependent on the amount of funds the entrepreneur ends up using.
If a business owner needs to establish a favorable credit history, a business line of credit could help him or her do that.
A seasonal business might favor a line of credit because its cash flow tends to be less consistent from month to month. Manufacturers, service companies and contractors are other common candidates for lines of credit, which help a business owner meet his working capital needs or bonding requirements without enduring a new application process each time with the help of a revolving line of credit.
Microloans are small loans that come from individual lenders, not from a bank or a credit union. Microloans can be issued by a single individual or they can be assembled from several lenders each contributing a given amount until the necessary funding total is achieved.
With a microloan, the lender gets interest on the loan and repayment of principal after the loan has reached its full term. Microloans come with interest rates that are above market, so some investors may be attracted by that aspect of them.
Another way to facilitate access to money needed to finance one’s business expenses is a merchant cash advance. In this instance, a company grants the borrower access to cash. The borrower is then required to pay a portion of her sales made with credit and debit cards, as well as an additional fee.
A merchant cash advance does not require collateral or a minimum credit score. However, merchant cash advances to immigrant business owners involve higher costs than most other forms of borrowing.
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