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.
To keep your business running smoothly from day-to-day, you’ll need access to working capital. From payroll to software subscriptions, your working capital should provide a healthy cushion for the predictable expenses involved in running a business.
But occasionally you have to pay for things you don’t budget for - and this can outstrip your available working capital. That’s when a working capital loan comes in handy…
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 provides working capital for short-term relief or to take advantage of time-sensitive growth opportunities, like a new client or a large purchase order.
Working capital loans come with short-term repayment periods and are not meant to fund investments that take longer than a few months to pay back. For these expenses you’d be better off with VC funding or a bank loan.
Who would benefit from a working capital loan?
Working capital loans are a popular financing option for businesses who have a short-term need for finance - either to fund growth or help recover from a temporary shortfall in sales.
So if you’re looking to invest in advertising you know you’ll make a quick return on, bridge a seasonal shortfall in sales, or pay employees on time after a challenging month, a working capital loan will help you cover these operating costs.
For example, there are many ecommerce businesses that sell the most during the holiday season. To help prepare for this period, many apply for working capital loans to secure inventory and cover the operating costs needed to get through the off-season.
Types of working capital loans
As soon as you start looking for a working capital loan you’ll realize that you’re not short on options. Let’s take a look at the most common types of working capital loan:
Lenders provide capital that you repay over a set period of time with regular payments. This is a popular option due to its straightforward repayment process. You always know what you owe, and when you owe it.
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 most loans because you can draw cash and deposit repayments so 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.
In the US, loans from the Small Business Administration are typically capped at $5 million. To get a loan, you’ll probably be asked to share your credit history, details of existing collateral, a plan for how you’ll use the funds, financial projections and proof of industry experience.
You can sell your unpaid invoices to a factoring company who will give you capital upfront and collect payments as customers pay their invoices. Read more about invoice factoring in our article on ecommerce funding types.
How to get a working capital loan
You can apply for working capital loans from banks, credit unions, and various online lenders.
When it comes to borrowing costs, banks and credit unions typically offer the lowest APR (annual percentage rate), but they are also the hardest to qualify for. They have strict credit and revenue requirements and may even ask for collateral.
If you don’t qualify for a working capital loan with a bank or credit union, you can often find online lenders that have more flexible requirements. However, this flexibility comes at a price; working capital loans from online lenders typically have a higher APR.
Some of the biggest differences between online and traditional lenders are found in their application processes.
Before you apply for a working capital loan, you should prepare everything you need:
- 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, working capital loans provide the capital you need to operate your business, but can also present a major risk to your long-term finances and personal credit history.
- No loss of equity - You can maintain ownership of your business and won’t have to give up any equity to secure funding
- 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.
- Limited restrictions on how to use the loan - You can use your influx of capital how you want. Lenders don’t have oversight on what you put the money towards.
- High APR - Since they are meant to be a short term financing option, working capital loans tend to come with high repayments and APR. The typical APR for working capital loans are anywhere from 5%-80% depending on the specific loan product you apply for.
- Tied to personal credit - A working capital loan can hurt your credit score if you miss payments. 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 use the capital in whatever way you think will benefit your business most. Here are some of the most common ways businesses use a working capital loan:
- Expand headcount
- Cover existing 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 a great option for business owners looking for flexible, short-term funding. Businesses that benefit from these loans usually know they’ll be able to quickly repay the loan.
Businesses will often seek out this loan if they plan to scale their business.
Additionally, working capital loans are perfect for those who need to cover operational expenses or want more cash flow throughout the off-season. For example, retailers who see low sales after the holiday season might turn to this option to tide them over until their next sales and marketing push.
During this time, a working capital loan can provide the capital you need to cover everyday expenses, like payroll, utilities, and rent.
Not sure if you currently have the working capital needed to achieve your business goals? You’ll need to work out your working capital ratio.
How to calculate your working capital ratio
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.
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.
Calculating Working Capital
Current assets = $200,000
Current liabilities = $150,000
Current assets - Current liabilities = Working capital
$200,000 - $150,000 = $50,000
Next, you can calculate your current ratio by dividing your current assets by your current liabilities.
Calculating Working Capital Ratio
Current assets = $200,000
Current liabilities = $150,000
Current assets / Current liabilities = Working capital ratio
$200,000 / $150,000 = 1.3
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.
What does a good working capital ratio look like?
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 situation in the short term.
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 this loan to take on new opportunities for growth.
Who is eligible for a working capital loan?
Business owners with good credit and predictable monthly revenue have the best chance at qualifying for an affordable working capital loan with the lender of their choice.
Most lenders have minimum requirements for your credit score, time in business, and monthly bank deposits.
If you don’t have great credit or significant business history, you can still find funding options that will work for your business. The downside is that you may have to pay a higher APR, offer collateral, and/or sign a personal guarantee.
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 you apply for. They can get expensive and have a higher APR than a longer-term business loan or other funding 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 in a nutshell
Working capital loans are a short-term solution to help you sustain or grow your business. They work well as a short-term financing option, when you’ve got a clear idea of how and when you’ll pay the loan back.