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Working Capital Loans

A working capital loan is business loan to cover normal operating expenses. A business will usually take a working capital loan to cover expenses when there is a shortfall in revenues versus expenses.

Business Loan University: Working Capital Loans How to find the best business loans in 2024

What you need to know about working capital business loans.

Working capital loans are a type of business financing designed for short-term, smaller-sized business activities. Most frequently, these are loans that help to cover occasional operational expense shortfalls and to help keep your business running without interruption.

Generally speaking, a working capital loan will be smaller in size and will have a shorter repayment period than other business loans, usually within one year.

The main reason for a working capital loan is mainly to cover revenue or cash flow shortfalls caused by seasonal sales cycles or slow-paying receivables. Having enough working capital on-hand or readily available can mean the difference between success and failure of a small business. Therefore, it’s very important to understand the need for working capital, what it’s used for and how to make sure you have enough working capital to allow your business to run without interruption.

Used properly, working capital loans can help you to overcome temporary cash flow shortages or take advantage of timely business opportunities before they disappear.

Types of Working Capital Loans

While the term “working capital loan” is used generically, it relates to any type of loan used by a business to access smaller amounts of capital in a timely manner with the intent that it will be paid back in a shorter time-frame than other loans used for specific purchases such as machinery or real estate. A working capital loan is also usually associated with an unforeseen or one-time event.

Let’s look at some of the more popular types of working capital loans:

  • Short term loan

    This type of loan is generally made through a bank or credit union. Short term loans are different from lines of credit in that they will generally carry a fixed rate of interest and the loan amounts will be made in a lump-sum disbursement, all at one and have a defined repayment period (usually one year or less).

    A short-term loan is also commonly a secured loan, which means that you will need to post collateral or some asset to cover the loan amount in case of default. However, depending on your history with the lender and the loan amount, some banks and credit unions will grant unsecured short term loans. Remember, getting approved for a loan can be a subjective process and terms are often negotiable.

  • Invoice Factoring

    Is a type of financial transaction where a business may sell all or a portion of its accounts receivables (unpaid invoices) to a third party at a discount. Invoice factoring allows a company to get immediate cash for its outstanding (unpaid) invoices immediately, in exchange for discounting the full amount of the invoices. The obvious downside is that the company gives up a portion of their earned revenue in the process.

    Invoice Factoring can be expensive, so do your homework and get as many quotes from lenders as is practical; rates can vary widely from lender-to-lender.

    Keep in mind that there is a difference between Invoice Factoring and Invoice Financing. Invoice Financing is a term used to describe a type of asset backed lending where your unpaid invoices are used as collateral to obtain a more conventional loan, such as a short-term loan.

  • Merchant Cash Advances

    A merchant cash advance is commonly used by businesses that accept credit card payments for goods and services. Typically, the business’s credit card processor or another financing company will provide (or advance) amounts based on a portion of the historic monthly dollar volume of the merchant’s credit card sales. The advance is then paid back to the funding company directly as a portion of the future credit card sales.

    For example, if a merchant has average monthly credit card sales of $50,000, the financier may advance $20,000 and automatically take 40% of all credit card sales in the following month until the advance fees are paid. This is an overly-simplified example and funded amounts and repayment schedules are generally based on formulas offered by the credit card processor.

    Also, a merchant cash advance can be arranged with third-parties (not necessarily with the credit card processor) where the business authorizes the third party lender to be paid directly from credit card sales or through fixed payment plans.

    Check out this helpful blog from Biz2Credit to learn more about merchant cash advances.

  • Working Capital Line of Credit

    A business line of credit can be understood as a cross between a business loan and a business credit card. Like a business loan, an unsecured line of credit provides business financing that can be used for general business expenses. However, with a line of credit, there is no lump-sum disbursement; a business owner borrows only what is needed and only pays interest on the amounts borrowed.

    A line of credit is ready cash and can usually be used immediately. With a line of credit a business owner has a fixed amount (limit) of cash to draw upon and will know the interest rate in advance. In addition, you will only pay interest on the amounts you actually borrow and use.

    Also, the more you use your line of credit, and pay it off in a timely manner, the greater chances you will get higher limits and lower interest rates. It’s a practical idea to be proactive in establishing a business line of credit and use it as a sound financial discipline for your future working capital needs.

    The best time to apply for a business line of credit is when your company finances are strong and business is thriving. If you wait to apply for a line of credit when your company falls on hard times, you may run the risk of being declined.

  • Bank Overdraft Facility

    A bank overdraft facility or commonly called “bank overdraft protection” is an arrangement with your bank that allows you to draw against your account beyond what you have on deposit and you do not incur any overdraft penalty fees. The benefit to this type of arrangement is that you only pay interest on the overdraft amount. This is particularly helpful in cases where your accounts receivable are slower to pay and you have unexpected shortfalls in your account. Having an overdraft facility allows you to pay your bills, ovoid penalties and stay in good standing with your bank.

  • Small Business Administration (SBA) Loans

    The US Small Business Administration is an ideal source for working capital loans. Many business owners are unaware that the SBA loan guarantees smaller loans for businesses. Specifically, the SBA 7(a) loan is well suited for smaller amounts used for working capital. The 7(a) program working capital loan program can range anywhere from $5,000 to $5 million.

    Remember, the SBA does not lend money directly to businesses; they work with approved lenders to guarantee loans to businesses. To qualify for an SBA loan, you will need to have strong credit and you will need to fill-out additional paperwork. However, SBA loans usually have lower interest rates and more favorable repayment terms.

    Check out this helpful blog from Biz2Credit to learn more about SBA loans.

Top Reasons Businesses Use Working Capital Loans

The best reason to take out a working capital loan is to keep your business running without interruption. However, there are some things that you should know about working capital loans and common occurrences where many businesses find the need for this type of loan.

Remember, when taking a business loan, you need to keep in mind the cost of borrowing. Business loans have become highly specialized for different circumstances and uses. Short-term borrowing is often more expensive, so understand how you intend to repay your loan and what it will cost. The following are typical scenarios where companies choose to take out working capital loans:

  • Seasonal revenue fluctuations

    A boat rental company operating in the Northeast United States will have its busy season from late spring to early fall. It may even cease operations completely from late fall to early spring, but will still have to maintain its facilities, pay staff and pay rent. It is unlikely that this type of business will have any revenue during the off season, so it may be necessary to borrow in early spring to conduct repairs, buy new equipment and get staffed-up for the busy season.

  • Unforeseen expenses

    Business, like life, can be highly unpredictable and virtually every business will experience an emergency financial situation at some point in time. Machines break down, equipment can be lost or stolen, and disasters may damage infrastructure or inventory. And despite being insured, claims can take a while to be paid. Having access to immediate, ready cash in an emergency can mean the difference between thriving and failing.

  • Growth

    Many small businesses encounter growth opportunities within a small window of time. Whether it’s a renovation of physical space or the chance to move into a new popular location, having cash on hand to make a decision quickly can be crucial.

    Many small businesses also experience unexpected growth spurts. For example, a popular food blogger might write a good review for a restaurant and suddenly reservations triple. Would you have enough space, food and staff to handle the growth? Or perhaps your hotel is reviewed by a popular social media influencer as an ideal destination. Could you handle being an overnight success? Success for your business is a good thing, so don’t let cash flow issues cause that success to turn sour.

  • Buying Inventory

    Many savvy retail business owners will tell you that they make their money buying their merchandise, not selling it. While this is more of an idiom (of course you have to sell your products to make money), the phrase is meant to stress the importance of being able to buy at the right price to increase profit margins. This may mean buying more of your popular items and getting bulk price discounts or an opportunity to buy rare items. Working capital loans can help you take advantage of these kinds of supply opportunities.

  • Inconsistent Cash Flow

    This is different from seasonal fluctuations and is notorious in the service industry. Many service businesses will send invoices for services. In the event of default, a service provider cannot often reclaim their service like someone who sells physical goods. In general, service invoices can take longer to collect. If your receivables are lagging far behind your payables, you may need to consider a working capital facility.

  • Equipment Purchases

    Equipment financing is a type of small business loan used primarily to purchase business equipment like computers, machinery, vehicles or most any business equipment. Business owners may use the new equipment as collateral for the loan, making equipment financing a smart way to preserve on-hand cash.

How Much Working Capital Does Your Business Need?

If you are considering a working capital loan, you are probably asking yourself: what is the right amount? Naturally, the answer is that you will need enough money to pay your regular bills and any debts. Business owners need to understand the full picture of how to make their overall business assets work for them, beyond just paying expenses and debt. This is not always intuitive.

What is a Working Capital Ratio?

A ratio for a working capital loan will help you understand your financing needs. Using a simple formula business owners can get a sense of what they may need in terms of working capital. It’s called a working capital ratio. This is not a hard rule and your company may be different, but consider the following. Here is the working capital formula:

Working Capital Ratio = Current Assets / Current Liabilities

For example, let’s say your company has 62,500 in assets and $50,000 in current liabilities. 62,000 / 50,000 = 1.25, so your working capital ratio is 1.25. According to Value Penguin, you want a ratio between 1.2 and 2.0.

Lenders, creditors and partners will all assess working capital to get a sense of business's health. If a business has either negative net working capital or a working capital ratio below 1.0, the business either has notable liquidity issues or isn't productive enough compared to how much debt it’s taking on. Whatever the case is, it's a serious red flag.

The working capital equation helps businesses find the sweet spot between paying existing debts and expenses while preparing for future business growth.

This equation can also help you figure out how much you should borrow in a working capital loan.

Working capital checklist

By taking stock of your short-term assets and liabilities, you may get a better understanding of your working capital needs. This working capital checklist is a quick guide to help you assess your cash position and decide if you could need a working capital loan.

Assets (working capital on-hand)

Cash Position

  • What are your cash and cash equivalent positions?
  • If you maintain a cash working account and plan to fund your working capital needs from the surplus in the account, be sure that you
    1. have enough funds to cover expenses; and
    2. plan for a cushion by over-estimating expenses by 15%-20%.

Liquid Investments

  • Short-term investments (up to 1-year maturities), such as money market or CD’s are a smart way to build a working capital “war-chest”.
  • Review any short-term financial instruments held by the company.

Prepaid Expenses

  • Pre-paying expenses can be a way to reduce long-term cost and earn discounts.
  • Every time you pre-pay a business expense, you draw from your current working capital on-hand.
  • Review your pre-payment policies twice a year.

Accounts receivable

  • Do a formal credit check on new customers
  • Send invoices in a timely manner on regular intervals
  • Be proactive as the payment due-date approaches with email or follow-up call campaign
  • Do not rely upon “accrued interest” from late payments. Interest payments are not an off-set to non-payment when it comes to working capital
  • Resolve billing disputes quickly and reaffirm payment agreements

Inventory

  • Be vigilant about tracking inventory
    1. Digitize inventory management as soon as possible
  • Discontinue unpopular items and/or discount them to move them into cash
  • Track historical sales by week or month
  • Try to maintain an equal balance between holding inventory and sales

Liabilities

Accounts payable

  • Pay on time and build a strong credit profile. Vendors will be more inclined to extend payment terms.
  • Coordinate payment and receivables cycles. This may mean starting an account with a pro rata payment or billing for the first cycle.
  • Anticipate cash shortfalls by speaking with debtors before your payments are due. This is a positive, proactive behavior that usually will get you a grace-period extension without penalty.
  • Do not make pre-payments unless you get better terms or discounts.

Short-term debt

  • If using a working line of credit, ensure that you have over-run funds available in the event of unforeseen expenses
  • Make it a point to flatten your overdraft or line of credit balances as soon as possible. If you cannot achieve this, you may need to restructure your debt.

Summary and Last Thoughts on Working Capital Loans

How do I know if I need a working capital loan?

A working capital loan should be treated as any other business loan. You should justify the purpose of the funds before you every take the step to apply. Once you have concluded that there is a business justification for the loan, you should very clearly define how the money will be used. It is equally important to make sure you use the capital for the purpose you have identified. “Spending creep” is the notion that people (and businesses) tend to spend free cash in ways that do not contribute to intended outcomes. Be very diligent about how you spend the money.

Will this loan improve my business and can I repay it?

As an added justification to taking out any loan, ask yourself: will this loan improve my business? If you cannot answer clearly and with purpose, perhaps you should not take the loan. Along with that, you need to be certain that your business can repay the loan. This may seem obvious, but it’s often overlooked.

Is a working capital loan the best way to finance my business?

Before signing on the “dotted line” to get your working capital loan, do you understand the true cost of the loan? Have you calculated all the fees and interest payments? Finally, is there a better way to finance my working capital needs? Very often, a working capital loan or financing will help you overcome cash flow issues and grow your business, but you should always be careful with how you choose to finance your company.