If you’re a first-time small business owner, the sheer number of financing and loan options available to businesses like yours can be overwhelming. In this article, we focus on working capital loans and tell you everything you need to know about them, including what they are, when you might need one, and how to apply.
What is Working Capital?
Simply put, working capital is the money your business has readily available for daily operations and expenses. It is one way to measure your company’s liquidity, and also serves as a gauge of overall financial health.
Working capital is calculated by taking the difference between your current assets, which include cash, inventory, and anything that could be liquidated in a short amount of time, and your current liabilities, which include accounts payable, employee wages, rent, and utilities. It is essentially the cash your business has available to cover operational expenses.
The Pros & Cons of Working Capital Loans
There are many reasons you might end up needing extra funding in the course of doing business. For example, if you own a landscaping company, you might find that business gets really slow in the colder months, leaving you short on funds as you wait for spring. If you are a graphic designer, you might find a dip in the summer when prospective clients are on vacation.
Sometimes, business slows temporarily for no discernable reason, or you hit a stretch where an unusual number of clients are behind on paying you. Or perhaps you just need more upfront funds to cover the cost of supplies and materials in anticipation of big jobs coming down the pipeline. Whatever the reason you are considering a working capital loan, it’s worth knowing the pros and cons.
- A loan provides you with cash to cover daily operating costs associated with doing business.
- A loan can allow you the temporary funding you need to avoid financial disaster.
- There are generally no rules around what you can spend the funds on.
- Working capital loans are often processed quickly compared to other loan types.
- These types of loans often require little or no collateral.
- Any money you borrow will need to be repaid with interest, meaning you will pay back more money than received.
- Interest rates on working capital loans may be high.
- Taking out loans impacts your credit rating.
- Working capital loans are usually short-term loans, meaning they need to be repaid quickly.
- These types of loans don’t offer a long-term financial solution. Instead, they’re meant to address only short-term financial needs.
How to Get a Working Capital Loan
Working capital financing can come in many forms. Before considering your financing options, take some time to assess your working capital needs and what type of repayment plan you could manage. Factor in monthly payments on the loan amount into your budget.
Working Capital Short-Term Loans
Most working capital loans are short-term, unsecured loans. Borrowers are often small businesses in need of short-term funding. Online lenders offering this type of working capital loan include Kabbage, Currency, and LendSpark.
The loan application process may vary from lender to lender. Some may allow you to see if you prequalify without impacting your credit rating, which is great if you want to consider your options without committing to anything. Whether you are approved depends on your personal credit score or credit history. Sometimes, lenders prefer to make their decisions based on your company’s financial records.
The interest rates you will qualify for can vary, as well, and are often much higher on these types of loans than on other loans. This is because these loans are short term and often require little or no collateral. Always consider your business needs and ability to repay when deciding how much to borrow.
Working Capital Lines of Credit
A business line of credit is an option for businesses whose cash flow needs might be unpredictable. For example, if you’re a small business just starting, you may need to cover gaps when you have few clients or when clients pay late from time to time.
A working capital line of credit allows you to borrow up to a certain limit whenever you need it. You don’t need to borrow the full amount and can take what you need, pay it back with interest, and tap into the line of credit again if needed. Because of this, lines of credit are more flexible than traditional loans.
You can apply online for a working capital line of credit at any number of financial institutions, including Fundbox and BlueVine. The application process is generally straightforward and can be completed in minutes.
Merchant Cash Advances
If your business has a credit card merchant account, another option is a merchant cash advance. This is not technically a loan, but a lump sum payment that is an advance on your future credit card sales. The merchant cash advance provider transfers funds to your bank account and takes an agreed-on percentage of your future credit card sales until that amount is repaid.
Although not technically a loan, merchant cash advances often come with steep additional fees. Often, the borrowed amount is multiplied by a factor rate — a number usually between 1.1 and 1.5 — to determine the total amount you need to repay. What this means is that you end up not only repaying the initial amount but also an additional 10% to 50%.
This is why it’s important to be careful when considering merchant cash advances — they can be extremely costly. That said, if you can find one with a decent rate, it would make the difference between saving your business and filing for bankruptcy. If you can’t obtain funding from other sources due to credit issues, it might be worth considering.
Many merchant cash advance companies exist online, and many lenders who offer small business loans and lines of credit also offer this option, as well, including Credibly, which boasts 24-hour approval and the ability to prequalify quickly.
Invoice financing allows you to borrow money against amounts due from your customers. This might be a solution for your business funding problems if the shortfall is due to late payments.
This type of financing typically works in one of the following two ways. One way is called invoice factoring. How it works is that you sell your invoices directly to the lender, the lender pays you a percentage of the invoice (e.g., 75%) upfront, and when the lender receives payment, they will give you the remaining amount of the invoice minus any interest or fees.
The other way is called invoice discounting, in which the lender provides you an advance on the invoice amount, and you repay the lender with any fees or interest when the invoice is paid. This method may be preferred to avoid the bad optics of having your invoices going to a lender but may be considered riskier from the lender’s point of view.
Traditional financial institutions, such as banks and credit unions, offer Small Business Administration (SBA) loans. These loans are often more substantial and longer term than the working capital short-term loans. As such, the application process may be a little more involved.
Rates on these loans are often lower than some of the options above because these loans are guaranteed by the SBA. So, if you need more significant funding that you’d like to pay back over a longer term, you may want to consider looking into an SBA loan.
Working Capital Loan Interest Rates and Fees
Interest and repayment add to the monthly costs of your business and can eat into whatever slight margins you might already be operating on. That’s why it’s important to be aware of the interest rates and fees that can come with taking out a working capital loan.
While your credit will factor into the interest rate offered, keep in mind that it’s not the only factor. It may also depend on what the lender wants to offer and how long you’ve been in business. And when it comes to fees, some loans come with origination and application fees.
While a working capital loan can be beneficial to your business, you might want to consult with a financial expert to determine the exact format and amount that’s best for you.
Expanding Your Small Business
We hope this guide has provided you with the information you need to make informed financial decisions when it comes to capital funding for your business. Check out ZenBusiness’s additional resources to help you grow your small business or startup. Our goal is to make it easy to fulfill your dreams by offering you the services you need every step of the way.