Working Capital Loans: What They Are and How They Work
May 12, 2022 | Last Updated on: July 25, 2022
May 12, 2022 | Last Updated on: July 25, 2022
In this article, you’ll learn:
Your working capital, which is your current assets minus current liabilities, is one of the most important measures of the short-term financial health of your small business.
A company with 2x as many current assets as current liabilities is likely in a strong position to cover its financial obligations over the next year, as its current assets are going to be turned into cash over the same period that the current liabilities need to be paid. A company with low or negative working capital, on the other hand, may need to take out a working capital loan to grow or pay back creditors.
A working capital loan is a loan that is used by companies with insufficient working capital to cover short-term financial obligations, such as accounts payable, notes payable, and taxes payable that are due over the next 12 months.
Let’s look at common uses for business working capital loans, and how this small business financing solution is typically structured.
Here are three common scenarios where small business owners need working capital loans:
For example, you have a business that sells holiday decorations and December is five times busier than the average month. In this case, you would need to purchase extra inventory to satisfy the elevated demand. Since your inventory is a current asset, however, your working capital could be at the ideal ratio of between 1.5 and 2… and you still might not have enough cash flow to both cover inventory requirements and short-term debt obligations. So, you might need a short-term working capital loan for December.
Staying with the holiday decoration business example, this type of business is going to have some slow months where there aren’t any major holidays – or at least none where people buy a lot of decorations. But the small business owner still has to pay their employees and cover other operating expenses, which could necessitate a working capital loan.
Your accounts receivable is a current asset, so it factors into your working capital. But if a few of your large buyers are late paying their invoices, you might experience a cash crunch. While you may have never had this scenario come to fruition, an industry-wide slowdown could cause it to happen.
There are countless other scenarios where a working capital loan would be necessary, but here’s the key takeaway: you can sometimes predict the need for a working capital loan (Scenario #1 and Scenario #2), but other times, working capital needs are going to be more unpredictable (Scenario #3).
With that in mind, you need to have quick access to working capital financing.
In most cases, a company’s working capital needs are very short-term in nature, as the working capital measurement – current assets minus current liabilities – only takes the next 12 months into account. So, the repayment terms on a working capital loan are typically 1-12 months. But there are instances where a business needs to extend for longer than 12 months, such as a startup or new business that expects to generate very little revenue over the next couple of years… but has a promising long-term business model.
With working capital loans, the interest rate varies a lot depending on the type of loan. There are some types of loans that charge single-digit interest rates and others that charge high double-digit – or even triple-digit – interest rates.
You may be wondering: how could a small business owner pay an astronomical interest rate on a working capital loan?
The thing is, they aren’t paying that much in dollar terms in many cases, since working capital loans often have repayment terms of a few months. A 30-year loan with a 100% interest rate would be a completely different story.
Let’s look at several working capital loan options for small business owners.
The U.S. Small Business Administration (SBA) 7(a) loan program provides small business owners with a maximum loan amount of $5 million, and guarantees as much as 85% of the loan – depending on the loan amount. It’s possible to use an SBA loan to satisfy working capital needs, and the guarantee allows small business lenders to offer very attractive repayment terms.
To qualify for an SBA 7(a) loan, you have to operate for profit, have reasonable invested equity, and be able to demonstrate a need for the loan proceeds, among other eligibility requirements.
There’s a catch with SBA loans, though: the “time to cash” can be months, making it an unrealistic way to satisfy unpredictable working capital needs. In addition, the interest savings aren’t likely to amount to much if you have short-term needs. This means that an SBA loan is a good way to meet working capital needs if you satisfy the following three conditions:
A term loan provides a small business owner with a lump sum of cash, and the borrower agrees to repay the loan at a fixed or variable interest rate on a predetermined schedule. The loan amounts, length of the loan, and interest rates vary depending on the lender. But to give you an idea of what’s available, here’s what we offer at Biz2Credit:
It’s not easy to qualify for a term loan, as most customers get started with $250k in annual revenue, a 660+ credit score, and at least 18 months in business. The 1-3 year repayment period means that a term loan makes sense for long-term working capital needs.
By using an online lender, such as Biz2Credit, you can get business funding in as little as a few business days. With that in mind, a term loan with an online lender is ideal for unpredictable long-term working capital needs, such as an industry slowdown that happens suddenly.
You probably want to avoid credit card debt at all costs, but a business credit card is sometimes a good way to satisfy short-term working capital needs – the interest on the debt is likely to be very low over, say, two months. Here’s another benefit: once you have a business credit card in hand, you can use it to finance business purchases whenever necessary.
In many cases, business credit cards offer 0% APR introductory periods of between six and 18 months, so you may be able to completely avoid interest payments for a while. To qualify for the best business credit cards, you typically need a high credit score.
A business line of credit gives a small business owner access to a specified loan amount, but there is no loan disbursement; you only borrow what you need, and only pay interest on the amounts borrowed.
The interest rate on a business line of credit is typically variable, as the lender wants to protect itself if market rates increase by the time the borrower taps into the business line of credit. While rates can increase significantly, a small jump is unlikely to have a big impact on your total amount to be repaid on a short-term loan.
The eligibility requirements are usually not too hard to satisfy for a business line of credit, as a 580+ credit score, 12 months in business, and $10,000 in average monthly revenue are sufficient with many alternative lenders.
A merchant cash advance (MCA) provides a small business owner with a lump sum of cash, and the borrower pays it back based on a percentage of future sales – calculated based on a factor rate, not an interest rate. You multiply the factor rate (usually between 1.2 and 1.5) by the amount borrowed to get the total amount to be repaid.
For example, you borrow $50,000 with a factor rate of 1.4. In this case, the total amount to be repaid would be $70,000.
The repayment period for an MCA is usually less than one year, making it a great option for working capital needs. While the effective interest rate is often on the higher end – high double-digits or low triple-digits – the short-term nature of this financing option means that the overall fees aren’t that high in the grand scheme of things. In addition, it isn’t too hard to qualify for a merchant cash advance; a credit score of 525 or higher could allow you to get an MCA.
Invoice financing allows you to borrow money based on your outstanding accounts receivable, providing you with 80-90% of the value of your unpaid invoices. In most cases, you have to pay a flat percentage (1-5%) of the invoice value in fees. Since invoice financing is usually a very short-term financing option, however, this 1-5% is much higher on an annualized basis. Your ability to wait longer for your invoices to be paid has to be weighed against the cost of the funds.
You can qualify for invoice financing without a great credit history.
With invoice factoring, you sell your outstanding invoices to a company; you usually get around 85% of the money upfront and the rest (minus fees) after the invoice is collected. The fee, known as a factoring fee, is often 1-5%.
If you’re considering using invoice factoring, you should read up on recourse and nonrecourse factors – which one you pick can have a major impact on your small business.
As a small business owner, you are likely going to need more working capital at some point. In that case, you want to pick the right type of financing for your small business.
By using an online lender, such as Biz2Credit, you can get a small business loan with attractive terms – and without a long wait. Humphrey and Lydia Gichere, two healthcare entrepreneurs, used Biz2Credit to meet working capital needs. Humphrey said, “There is no business that does not receive working capital funding, and Biz2Credit is simply the best.”
Learn how Biz2Credit can help your small business secure working capital financing.
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