The Definitive Guide to Working Capital for Business Owners
November 5, 2024 | Last Updated on: November 5, 2024
Disclaimer: Information in the revenue-based financing articles is provided for general information only, does not constitute financial advice, and does not necessarily describe Biz2Credit commercial financing products. In fact, information in the revenue-based financing articles often covers financial products that Biz2Credit does not currently offer.
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A small business owner always needs to have enough cash on hand to cover day-to-day and short-term expenses. The key to uninterrupted business operations and financial health is working capital. Cash flows can fluctuate from month to month. Exploring other business financing options, will ensure enough working capital is available.
Working capital is used to purchase inventory, make debt payments, and cover operating expenses. Maintaining smooth business operations and meeting financial obligations is dependent on working capital.
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. Even more become vulnerable during challenging times, like a stock market crash or pandemic. A business capital loan can keep a company going during tough times.
How can companies secure business capital loans?
1) SBA Loans
The U.S. Small Business Administration (SBA) offers business capital loans that are partially guaranteed by the government. Since the risk is reduced for the lender, terms are improved for the borrower. The SBA also can help entrepreneurs qualify for business capital loans. One SBA loan product that features low down payments and interest rates is the SBA 504 Loan Program. This program helps businesses invest in their facilities, expand their reach, and give them more stake in their community. The SBA 504 program was developed help small businesses grow.
Business capital loans secured through the SBA have several benefits. They offer a larger selection of loan sizes. SBA loans also offer more attractive repayment terms than traditional loans. The interest rates on SBA business capital loans can also be lower than other types of short-term funding.
SBA loans require a lot of paperwork. There’s a lot of forms you need to fill out. Approval depends on the applicant’s business history and credit score. Despite the additional paperwork and longer wait times, lower rates make SBA loans a preferred funding type.
The length of an SBA business capital loan can range from five to 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 business capital loans are most frequently approved for the following types of companies:
- Restaurants (full and limited service)
- Medical offices
- Beauty salons
- Gas stations (with convenience stores)
- General contractors
- Landscaping services
- Trucking/logistics
2) Short-term Online Loans
When a quick, affordable infusion of cash is needed, a short-term loan might be perfect. Short-term small business capital loans range from three to 12 months. These loans are more likely to require collateral than longer term loans. However, due to shorter terms and less fees, short-term loan can save you money. Short-term loans are widely available, but are targeted toward consumers with established business credit.
The credit requirements are not as strict for short-term business capital loans as they are for regular term loans. However, the frequent payment schedule may be burdensome for someone in a new business to maintain. Short-term loans from online working capital lenders may be easier to get than other types of loans.
Choosing to apply for a short-term loan comes with the expectation that you might have to repay it quickly. 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 loan. Sometimes approval could even come the same day the application is placed. Short-term online loans for working capital include paying less interest, improving credit, and flexibility.
3) Invoice Factoring
There are other options for getting working capital. Invoice factoring is the process of selling unpaid invoices at a discounted rate. In exchange for the company’s invoices, they receive a lump sum of cash that can be used as working capital.
After purchasing the business owner’s invoice, the factoring company collects payments from the business’ customers. The lump sum that the business receives in exchange for those unpaid invoices covers cash flow shortages. The business will sell the invoice to the factoring company at discount, to account for the factoring fee. Using factoring, lets businesses 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.
Drawbacks to invoice financing for business capital funding include surrendering control, negative impact on credit, and factor fees.
4) Crowdfunding
Some small businesses consider raising working capital with a little help from their friends. Crowdfunding is a way to do that. Using the combined contributions of friends, customers, and investors is called crowdfunding.
There are several advantages to crowdfunding. These include:
- reaching a broad audience
- showcasing your company’s strengths to investors
- the attention you get from being on the crowdfunding platform
- efficiency
Crowdfunding allows entrepreneurs to streamline fundraising efforts with a single profile. This way all prospects and potential investors can use the same platform. Presenting your business to a large audience all at the same time eliminates many of the inefficiencies.
Crowdfunding can be based on donations, rewards or equity. Funding that is based on donations means that there is no financial reward to the donor. A campaign based on rewards would give something back to the contributor, such as a product or a service. Equity-based crowdfunding invites contributors to become part-owners of the business.
5) Peer to Peer Loans
Peer-to-peer loans work when investors directly provide funding to a business or consumer. Peer to peer business loans are offered directly to individuals without the intermediation of a bank or traditional financial institution. 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 traditional bank would do, a p2p platform will investigate the finances of the small business owner who is seeking a loan. Investors will want to review the borrower’s credit score and payment history. They may want financial documents to determine if the debt-to-income ratio merits funding the loan request. All of this information will be available on the platform. The request is also given a score helping potential investors quickly assess 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 share of the interest payment and the principal payment back in his account.
How Much Working Capital Does a Small Business Need?
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 everything the company owes within 12 months. Businesses with physical inventory require a lot of working capital to operate. Retail, wholesale businesses, and manufacturers all would fall into this category because they need to constantly buy raw materials to make or sell inventory.
Seasonal businesses, such as retail operations that have a “busy season” and a slow time of year, also need a lot of working capital. However, there are also business that require less working capital, like a company that provides only services.
The goal should always be to pay short-term expenses with earned revenue. Naturally, a business that takes longer to produce and market a product may need to supplement working capital at times. A company that bills its customers instead of taking up-front payment also falls into the category of needing more working capital.
Getting Working Capital with Bad Credit
A poor credit rating is not 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 could request an extra amount of time to pay its debts to regular vendors. It is obviously more advisable to pay vendors early, which helps establish strong credit. However, if the business has a good relationship with the vendor, they may be flexible. A company in need of cash on hand could also ask vendors if it’s possible to pay off bills in installments.
A personal loan is another possible solution to covering short-term expenses. But borrowing money from family or friends can be risky.
There are lending options that are less demanding of strong credit. We’ve already discussed short-term online loans and invoice factoring. Three other financing solutions for a borrower with weak credit are lines of credit, micro-lending services, and merchant cash advances (MCA).
Lines of Credit
Pre-approved funding with a maximum credit limit 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. This makes them great for business growth.
The borrower is only paying interest on the amount that he or she has withdrawn, kind of like a credit card. A business line of credit can help business owners who are uncertain of the amount or timing of necessary funds. A line of credit can also help a business owner to build better business credit history.
The drawback to a business line of credit is higher rates. The interest rate and financing costs will depend on the borrower’s creditworthiness and withdrawn amount.
A line of credit works well for seasonal businesses because monthly cash flow is not consistent. Manufacturers, service companies, and contractors are other common candidates for lines of credit. Lines of credit are also used as bonding requirements, which avoids a new loan application for every instance.
Micro-lending Services
Microloans are small loans that come from lenders, not from a bank or a credit union. Microloans are issued by a single individual or come from several lenders. When more than one lender is involved, each contributes until the funding goal is reached.
With a microloan, the lender collects interest and principal after the loan has reached its full term. Microloans come with interest rates that are above market. This benefits the investors by adding interest income, but can be expensive for the borrower.
Merchant Cash Advances
Another way to increase working capital is a merchant cash advance (MCA). The MCA is a loan with the collateral being future sales. The borrower repays the loan as a percentage of their credit and debit card sales. The borrower also pays additional financing fees. A merchant cash advance does not require collateral or a minimum credit score.
FAQ
What is the working capital cycle?
The working capital cycle is the amount of time it takes for your company to turn current assets into cash. This is something you should always keep in the back of your mind as you evaluate your working capital needs.
How does working capital financing help a business?
Working capital financing helps you cover short term and day-to-day needs when your cash flow is down. It can be a strategic financial tool for managing your working capital cycle.
What is the working capital formula and how can I calculate it?
The working capital formula is a metric you can use to measure your company’s short-term financial health. Here’s how to calculate it:
Working capital = Current Assets - Current Liabilities
How can working capital management help my small business?
If you are just looking at your bank account and aren’t tracking your company’s working capital, you risk being underwater and not realizing it until it’s too late. By staying on top of your working capital status, you can effectively manage cash flow, take out working capital financing if you need it to cover short-term obligations, and reduce financial risks.
What options for working capital financing are available if I have bad credit?
With bad credit, you may still qualify for short-term loans, invoice factoring, merchant cash advances, and microloans.
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