Working Capital Loans: What They Are and How They Work

If you’re starting your first small business, or you’re a small business owner that worked their way up from the ground and didn’t go to business school, you’re likely familiar with profit and loss. But the term “working capital” may be new to you. Working capital equals your current assets minus current liabilities. It is one of the most important measures of the 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. Its current assets are going to be turned into cash over the same period to cover current obligations. Low or negative working capital, though, may indicate trouble.

In this article, we’ll look at how working capital loans can help your company strengthen its financial position and cover short-term needs.

What is a Working Capital Loan?

A working capital loan is used by companies with insufficient working capital to cover short-term liabilities. These may include accounts payable, notes payable, and taxes payable. Current liabilities are those that are due within the next 12 months. Unsecured working capital loans do not require any collateral from the borrower. Secured working capital loans require the borrower to pledge an asset as collateral if they can’t repay the loan.

How Do Working Capital Loans Work?

Let’s look at common uses for small business working capital loans. While loan amounts and repayment terms vary, the structure of these loans looks the same.

Common Uses

Three common scenarios where small business owners need working capital loans are:

1. You have to purchase inventory to prepare for the holiday season.

   For example, businesses that sell holiday decorations in December are many times busier in December than other months. In these cases, 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 to reach out to a few working capital lenders about funding options.

2. You have to survive the slow season.

   Staying with the holiday decoration business example, there are going to be some slow months. When there aren’t any major holidays coming up, sales will be down. But the business owner still has to pay their employees and cover operating expenses. In this case, the solution could be a working capital loan.

3. A few large buyers are late on their invoices.

   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 lender could help. The point is that you can sometimes predict the need for a working capital loan, like in scenarios #1 #2. However, at other times, working capital needs are going to be more unpredictable (scenario #3).

With that in mind, you may need to have quick access to working capital financing.

Repayment Terms

In most cases, a company’s working capital needs are short-term in nature. The working capital measurement takes current assets minus current liabilities. It only looks at the next 12 months, though, which is why loan terms with working capital lenders are 1-12 months. There are some instances where a business needs to extend for longer than 12 months. This is common for a startup that expects to generate very little revenue over the next couple of years but has a promising business model.

Interest Rates

With working capital lenders, the interest rates vary a lot depending on the type of loan. Loans with high interest rates may seem like a bad option, but keep in mind that working capital loans have short repayment terms. The total interest amount you would pay for a 30-year loan with a high interest rate would be much larger than what you would pay for a six-month loan with the same high interest rate. Your lender will provide the interest rate when they make their loan offer, so you’ll be able to evaluate them and see if you can justify the terms based on your business needs. It’s also important to note that interest rates can often be negotiated. If the rate is too high, consider going back to your lender with a counter offer to see if you can negotiate better terms.

Types of Working Capital Loans

Let’s look at several products from working capital lenders for small business owners.

SBA 7(a) Loans

The U.S. Small Business Administration (SBA) 7(a) loan program works with small business owners. They approve a maximum loan amount of $5 million and will guarantee as much as 85% of the loan amount. This guarantee allows working capital lenders to offer better repayment terms.

To qualify for an SBA 7(a) loan, there are eligibility requirements. You must operate for profit and have reasonable invested equity. SBA 7(a) loans also require the borrower to demonstrate a need for the loan proceeds. Most working capital lenders can provide a detailed list of requirements.

The biggest disadvantage to SBA loans is the time they take. It can take months for an SBA loan to get approved and funded. In addition, the interest savings aren’t likely to amount to much if you have short-term needs. An SBA loan is a good way to meet working capital needs if you satisfy these three conditions:

• Meet eligibility requirements.
• Have longer-term working capital needs.
• Can predict working capital needs well ahead of time.

Term Loans

Term loans are what most people have in mind when they think about a loan. A provides a small business owner with a lump sum of cash upfront. In return, the borrower agrees to repay it at a fixed or variable interest rate. Payments are typically monthly per a predetermined schedule. The loan amounts, length of the loan, and interest rates vary depending on the choice of working capital lenders. But to give you an idea of what’s available, here’s what Biz2Credit offers:term loan provides a small business owner with a lump sum of cash upfront. In return, the borrower agrees to repay it at a fixed or variable interest rate. Payments are typically monthly per a predetermined schedule. The loan amounts, length of the loan, and interest rates vary depending on the choice of working capital lenders.

Business Credit Card

It is a good idea to avoid credit card debt. However, a business credit card can be 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. Another benefit is that once you have a business card, you can make business purchases whenever necessary.

Some business credit cards offer 0% APR introductory periods. These periods of free interest last between six and 18 months. To qualify for the best business credit cards, you need a high credit score.

Business Line of Credit

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 rates for lines of credit tend to be higher than with traditional loans.

Merchant Cash Advance

A merchant cash advance (MCA) is a financing option that 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, if you borrow $50,000 with a factor rate of 1.4. The total amount to be repaid is $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.

Invoice Financing

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 must pay a flat percentage (1-5%) of the invoice value in fees.

The Bottom Line

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, you can get a small business loan with attractive terms – and without a long wait.

FAQs

Can I get a working capital loan for a specific purpose, like covering payroll?

Yes, working capital loans can be used for any operating needs.

Which type of loan has the lowest interest rate?

Interest rates depend on more than just the type of loan. Market conditions, credit scores, and the lender factor into rates as well.

Is invoice financing or invoice factoring better for a smaller business?

It really depends on the business’s specific needs. With invoice financing, you are basically taking a loan out and using your future collected revenues as collateral. Invoice factoring involves selling the invoices at a discounted rate.

Can a working capital loan help my business save money?

Yes, one example is when working capital loans are used to purchase bulk inventory at a discount.

Would an equity loan be a better financing tool for cash shortages due to a slow season?

Unlike equity loans, borrowing working capital loans does not affect the ownership of the business.

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