What Is a Working Capital Business Loan?
Businesses need funds to carry out their daily objectives. Managing inventory, maintaining equipment, paying employee wages, advancing marketing efforts — these are only a few of the many expenditures a company can expect to pay for on any given day. The funds used to take care of these daily expenses are known as working capital.
When a business doesn’t have enough to cover these costs, they can apply for a working capital business loan. These loans are designed to cover a business’s short-term financial needs for a set period of time. Because they have short terms, they are not suitable for long-term investments or asset purchases, unlike a traditional business loan. In fact, working capital loans sometimes don’t even require collateral from those with sufficient credit. They can keep businesses who are struggling or highly seasonal in nature solvent through periods of low sales.
Interested in learning more? Read further for a guide on how working capital loans can help business owners; the different types of working capital loans; different borrower requirements to keep in mind; and how these funds are best used.
Table of Contents
- 1 How Does Working Capital Work for My Business?
- 2 What Are the Different Types of Working Capital Loans?
- 3 Where Can I Get Working Capital Loans?
How Does Working Capital Work for My Business?
Working capital can be defined as a company’s assets minus its liabilities. This metric can give both business owners and investors a good idea of a company’s liquidity — its ability to cover short-term financial obligations.
A company with a high liquidity rate is making more than enough money to continue operating — a sign that it may soon be ready to reinvest some of this capital in order to grow. Investors see this as a good sign. On the other hand, a company with a low liquidity rate is barely making ends meet, which may be a sign that it will soon encounter difficulties. Obviously, these businesses do not attract investors.
Failing to maintain a good amount of working capital not only makes a business less flexible when it comes to addressing new or unexpected costs; it can prevent the company from achieving growth through investments. Naturally, this can create a cycle, landing entrepreneurs in a position where they may have to shutter operations.
Working capital business loans are a way to break this cycle. Using these loans, business owners can afford operational costs. After earning profits, they can pay off the loan.
What Are the Different Types of Working Capital Loans?
There are several types of working capital loans to consider before applying. Each of these has different terms and restrictions, making them more suitable for businesses in certain niches or with specific financial needs. Here are the most common types you’ll encounter:
These loans have a fixed interest rate and they must be paid back in a short, set period of time — usually one or two years. This type of loan is typically secured, meaning it requires collateral. However, if an applicant has good credit and a good relationship with the lender, they may be able to get a short-term loan without collateral.
If you will be unable to pay the loan back in the time requested, a short-term loan is a bad idea. Short-term loans also tend to have higher interest rates, which can leave businesses in a worse state at the end of the loan period than when it began.
Business Line of Credit
A business line of credit is much like a credit card. You can borrow up to a certain amount and pay interest only on the amount you borrow. As long as you don’t exceed the limit, you can withdraw cash and make payments as you see fit. They may be secured by collateral, depending on your credit and lender requirements.
This form of working capital loan is obviously highly versatile, though they usually have a variety of fees and can be difficult to qualify for. It can also open the door to fraudulent purchases, meaning business owners must be wary about who has access to the line of credit.
Merchant Cash Advance
If your business accepts many credit card transactions, a merchant cash advance (MCA) might be the right choice for you. This is a form of agreement in which a merchant (or credit card processing company) provides a business with a lump sum of cash in return for a percentage of all sales for a duration of time, or by paying a fixed amount from your bank account at set intervals, as well as any additional fees the lender may impose.
They typically have very high annual percentage rates, and relying excessively on MCAs often leads to cash flow problems down the line. While this isn’t technically a loan, it is a way to manage working capital.
Invoice financing involves borrowing money against unpaid invoices from customers. The invoices are essentially collateral for the loan. For this reason, it’s sometimes referred to as accounts receivable financing. This is useful for businesses that sell goods to large clients, such as wholesalers. Invoice financing also allows lenders to fulfill debt collection responsibilities so you don’t have to.
On the downside, service fees and a lack of control over the debt collection process may be negatives when it comes to finances and customer relations, respectively. Further, businesses that work with smaller customers will not find this form of working capital loan feasible.
Small Business Association Loans
A Small Business Association (SBA) loan is a working capital loan that is partially guaranteed by the U.S. government. However, note that the loan isn’t issued by the government. Instead, the SBA acts as a middleman between borrowers and a group of approved lenders. Because such loans are guaranteed by the SBA up to 85%, lenders can offer better terms to borrowers.
On the downside, business owners often must provide collateral in the form of their business’ property. Further, the application process requires a lot of time and effort. Borrowers must also have good credit in order to qualify.
Where Can I Get Working Capital Loans?
Many financial institutions will offer you working capital loans. Here is a comparison of some of the largest loan providers, including their loan amounts, annual percentage rates (APRs), and borrower requirements:
Loan amount: $5,000 to $5,000,000
APR: 15% to 68%
Borrower requirements: Companies that sell to other businesses in staffing, manufacturing, wholesale, trucking; have been in business for at least six months; have a FICO credit score of 600, and generate annual revenue of at least $60,000 may qualify.
Loan amount: $5,000 to $500,000
APR: 25% to 50%
Borrower requirements: Borrowers must have been in business in the U.S. for at least nine months, generate $42,000 in total annual revenue, and have no active bankruptcies.
Loan amount: $2,000 to $250,000
APR: 24% to 99%
Borrower requirements: Borrowers must have an operating history of at least one year, generate at least $50,000 in total annual revenue, a personal credit score of 560, and access to business checking or an online payment platform.
Loan amount: $5,000 to $500,000
APR: 9% to 99%
Borrower requirements: Those who have been in business for at least one year, generate $100,000 or more in annual revenue, have good personal credit (500 for personal loans and 600 for lines of credit), and have had no personal bankruptcies in the past two years may qualify.
Image Source: Deposit Photos
This post was updated September 9, 2019. It was originally published September 16, 2019.