Your working capital is the cash you have on hand to cover daily operating expenses, and is calculated by subtracting what you owe from what you own. The amount of working capital you have can be a helpful indicator of your business performance and current financial needs.
An influx of working capital can help keep your business stay afloat in times of trouble or even fund new opportunities as you grow.
If you need more working capital, you could benefit from a working capital loan
What is a working capital loan?
A working capital loan is a short term financing option used to support a business’s daily operating expenses. This type of loan is meant to increase working capital for short term financial relief or to take advantage of time-sensitive growth opportunities, like a new client or a large purchase order.
A working capital loan has a short-term repayment period and is not meant to be used to fund long-term assets or investments.
Who would benefit from a working capital loan?
Working capital loans are a popular financing option for seasonal businesses who need financing in the off season when traffic is slow. Additionally, it's a helpful option for any business with limited cash flow to cover operating costs.
You can use a working capital loan to ensure you always have the cash on hand to cover day to day operating expenses and keep your business running efficiently.
For example, many ecommerce businesses often make the majority of their sales in the holiday season. To help prepare, some ecommerce businesses will apply for a working capital loan in hopes to secure inventory and cover the operating costs needed to get through both on and off season.
When it comes to borrowing costs, banks and credit unions typically offer the lowest APR on working capital loans, but they are also the hardest to qualify for. They have strict credit and revenue requirements and may even require collateral if the loan is secured.
If you don’t qualify for a working capital loan with a bank or credit union, you can find online lenders that tend to have a more flexible qualification process. This flexibility comes at a price: working capital loans from online lenders typically have a higher APR.
The different types of working capital loan
When you’re in need of a working capital loan, there are a range of options that vary in borrowing costs and flexibility. Let’s take a look at the most common types of working capital loans.
Lenders provide capital that you repay over a set period of time with agreed upon equal payments. This is a popular option due to its straightforward repayment process.
Business lines of credit
Working in a similar way to a credit card, a business line of credit allows you to borrow money up to a pre-approved credit limit. This is a more flexible financing option than loans because you can draw cash and deposit repayments as long as you’re within your limit. A business line of credit can be secured or unsecured depending on your qualifications and the lender you choose.
These are loans guaranteed by the government, and available through participating banks, credit unions, or online lenders. These loans aren’t only for working capital but can be used for various business expenses. In the US, SBA Loans are typically capped at $5 million.
You can sell your unpaid invoices to a factoring company who will give you an upfront fee and collect payments as customers pay their invoices.
How to get a working capital loan
You can apply for working capital loans from banks, credit unions, and various online lenders. More traditional lenders require a high credit score or even collateral for secured loans. Although online lenders don’t have strict requirements for qualifying, these tend to cost a lot more.You can apply virtually with an online lender or in person with a bank or credit union, but specifics about your application process will vary based on the lender and financing option you choose.
Explore your options to determine the best lender for you based on your personal credit history, business performance and assets available for collateral.
Here are some steps you can take to prepare for a working capital loan:
- Gather all required documentation. Specific paperwork requirements will vary but lenders often ask for financial statements, tax returns, and bank statements.
- Calculate your current working capital and create a plan to determine how much capital you’ll need and what you’ll use it for.
- Review your personal and business credit history. Anticipate which lenders and loans you’ll qualify for.
- Check whether you’ll qualify for an unsecured loan. If not, identify which business assets you can put up as collateral for a secured loan.
The pros and cons of working capital loans
As with any loan product, working capital loans provide the capital you need to operate your business, but can also present major risk to your long term finances and personal credit history.
- No equity given away - You can maintain ownership of your business and don’t have to give up any equity just to secure the funding you need.
- Unsecured loan options - Some working capital loans are unsecured and may not require you to put up business assets. In order to qualify for this type of loan, you’ll need a high credit score and significant business history. If you don't have great credit, you’ll need to apply for a secured loan and put up one of your business assets as collateral.
- Limited restrictions on how to use the loan - use your new capital how you want. Lenders don’t have strict requirements or oversight on what you put the money towards.
- High APR - Since working capital loans are meant to be a short term financing option, they tend to come along with high repayments and APR. The typical APR for a working capital loan is anywhere from 5%-80% depending on the specific loan product you apply for.
- Tied to personal credit - In the case of missed payments, a working capital loan can hurt your credit score. Additionally, some loans and lenders may require collateral or a personal guarantee which could put your personal and business assets in jeopardy.
How a working capital loan can work for you
Since lenders don’t have many restrictions on how to use your loan, you can leverage the capital in whatever way you think is best for your business. Here are some of the most common ways businesses use working capital loans:
- Expand your team
- Hire new employees and cover payroll
- Finance equipment
- Replace old equipment and pay for repairs
- Add inventory
- Create new products or services
- Restock items for peak seasons
- Purchase a large amount of inventory at a discount
- Manage cash flow
- Cover operational expenses such as supplies, rent or debt payments
- Continue business in the offseason, times of low traffic or if you get a sudden increase in demand
- Always have enough cash on hand to prepare for unexpected costs
Is a working capital loan right for your business?
A working capital loan is most effective for business owners looking for flexible, short-term funding. Businesses that benefit from these loans often know they have the incoming revenue to make repayments over a short space of time.
Additionally, businesses will seek out a working capital loan if they plan to scale production growth and expand their business.
These loans are perfect if you need to cover operational expenses or if you’re a seasonal business looking to get through the off-season. For example, if you’re a retailer, you may have times of low sales, such as in the winter after the holiday season.
During this time, a working capital loan provides the working capital to cover day-to-day expenses, like payroll, utilities, and rent, as your sales slow down during off-peak periods.Not sure if you currently have the working capital needed to achieve your business goals?
Your working capital ratio, or current ratio, can help you understand where your business stands financially and if you have enough working capital necessary to grow.
First you’ll need to calculate your working capital by subtracting your current assets from your current liabilities. As a reminder, your current assets are anything you own that could be quickly turned into cash. This includes bank accounts, accounts receivables, inventory and other liquid assets.
Your current liabilities are any debt or expenses you plan to pay this business cycle. This includes utilities, rent, supplies, debt payments and accounts payable.
For example, if your current assets are $200,000 and your current liabilities are $150,000, your working capital would be $50,000. Calculating your working capital will help you determine exactly how much money you'll need if you decide to move forward with a working capital loan.
Next, you can calculate your current ratio by dividing your current assets by your current liabilities.
If we continue with the example from above, you would have a current ratio of 1.3. Let’s take a look:
200,000/150,000 = 1.3
A working capital ratio lower than 1 is considered negative working capital. This could mean your business is in financial trouble or close to it. In this case, a working capital loan could provide an influx of capital to help sustain your business and improve your financial standing.
A ratio of 1.2-2 is considered positive working capital, and means that your business is on track for growth. Businesses with positive working capital can leverage a working capital loan to take on new growth opportunities.
Calculate your current ratio to gain insight into your business performance and determine if a working capital loan is the best option for your business.
Who is eligible for a working capital loan?
Business owners with good credit and steady revenue have the best chance at qualifying for an affordable working capital loan with the lender of their choice. If you don’t have great credit or a significant business history, you can still find funding options that will work for your business. In this case, you may have to pay a higher APR, put up collateral, and/or sign a personal guarantee. Most lenders have minimum requirements for your credit score, time in business, and monthly bank deposits.
How payment is worked out
Since working capital loans are short term, the repayment process is typically less than a year, but can range up to 18 months. The specifics of your repayment will be determined by the lender you choose and the loan product you apply for. Working capital loans can get expensive and have a higher APR than other longer term financing options.
Working capital loans have a straightforward repayment process. Depending on your lender, you’ll make daily, weekly, or monthly fixed repayments. This money is withdrawn directly from your bank account until you repay your loan in full.
Working capital loans are a short term solution to help you sustain or grow your business. They can have a high APR and present a lot of risk or even put your personal credit on the line.
With these risks in mind, it's important that you understand your working capital and how a working capital loan could best be put to best use throughout your business. If you decide a working capital loan is the right choice for you, do your research to find the most worthwhile lender and loan that you qualify for.