What is a Working Capital Loan?

Small business financing has been a lifeline for many entrepreneurs during the pandemic, but small business loans can be a great way to unlock growth, even when times aren't so tough. Business owners can use financing as a tool to build their business through hiring, marketing, purchasing inventory, and more. With so many different types of small business loans available, however, it can be difficult to decide on a financing solution that suits your needs. 

One flexible type of financing, which is often a great option for small business owners looking to increase cash flow without taking on a long-term debt obligation, is a working capital loan. Working capital loans are typically best for short-term financing needs such as buying inventory, paying invoices, or covering payroll. Let's explore the role of working capital in a small business and how a working capital loan can work best for you.

Working capital explained

Working capital is the amount of cash a business has on hand to cover day-to-day business expenses like payroll, electricity bills, supplies, and rent, to name just a few. Your working capital can be calculated by subtracting your liabilities from your assets. If the resulting number is negative, or too low, you might decide that a working capital loan fits the bill.

What are working capital loans good for?

Working capital loans are designed to help cover short-term financing needs. Whether this is to meet payroll, buy supplies, replenish inventory, hire more talent - you get the idea. There are few limitations. Whatever the challenge, chances are a working capital loan can do the trick.

Pros of working capital loans:

  1. Unsecured Option: Working capital loans are often available as unsecured loans, which means you don't need to pledge collateral. This reduces the risk of losing valuable assets if you're unable to repay.
  2. Flexibility in Use: You have the freedom to use the loan funds for various business needs, such as covering operational expenses, purchasing inventory, or funding marketing initiatives. This versatility can help address your immediate financial requirements.
  3. Ownership Retention: Working capital loans allow you to secure financing without giving up ownership shares or equity in your company. You maintain full control of your business.
  4. Fast Application Process: Compared to some other types of business financing, working capital loans often have a straightforward and speedy application process. This can provide quick access to much-needed funds during cash flow crunches.

Cons of working capital loans:

  1. Credit Profile Dependency: Unsecured working capital loans are typically offered to businesses with strong credit profiles. If your business has a less-than-ideal credit history, you may not qualify for favorable terms or may need to consider alternative financing options.
  2. Interest Costs: The convenience of working capital loans may come with higher interest rates compared to secured loans or longer-term financing options. It's essential to assess the total cost of borrowing and its impact on your profitability.
  3. Short Repayment Terms: Working capital loans usually come with short repayment terms, often ranging from 6 to 18 months. This means you'll need to make regular payments in a relatively short time frame, which can affect your cash flow.
  4. Limited Loan Amounts: Depending on your business's financial health and the lender's policies, the loan amount for working capital might be limited. This may not fully cover all your long-term investment needs.

Before pursuing a working capital loan, carefully weigh these pros and cons to determine if it aligns with your business's financial goals and situation. 

There is more than just one type of working capital loan, however, and it's important to find the right business loan for your specific needs. Let's explore some of the most popular working capital loans

Term loan 

If you've ever taken out a home mortgage or auto loan, then you are probably familiar with how a term loan works. You receive a lump-sum upfront, which is repaid over a specified term with interest. The payment terms can range from daily to once monthly. 

Considering that working capital loans are meant to meet short-term needs, the repayment period is often short-term, and can be anywhere between 6 to 18 months. In order to qualify for a short-term loan, you typically need a couple of years of operating history under your belt. Lenders often suggest these loans for businesses with predictable cash flow, because you will be required to make regular payments. 

Depending on the lender, business term loans can be secured or unsecured. If a business owner's credit is in tip-top shape and they show little risk of defaulting, they could qualify for an unsecured loan. This type of loan would require no collateral (which could be the business itself or inventory, for instance). The interest rate on an unsecured loan could be higher than a secured loan since the lender is inheriting more risk in case of a default. If the loan is secured, the lender will specify the type of collateral that is required. 

Line of credit 

A line of credit could be the right working capital solution if you'd like to have cash on hand to cover expenses as they arise. A line of credit works similarly to a credit card in that you gain access to a pre-approved amount of credit that you are able to draw from as needed. The amount you qualify for is often based on factors like credit history and cash flow. 

With a line of credit, interest is only charged on the amount that is used and repayment begins when you draw on the capital, though there could be a monthly maintenance fee. If the line of credit is revolving, you can borrow up to the maximum amount, repay the loan and then borrow again. This is because the term hasn't reached maturity. If the line of credit is non-revolving, you can't borrow again after the balance has been repaid. 

Merchant cash advances

A merchant cash advance (MCA) is another type of working capital loan which allows you to trade tomorrow's earnings for cash today. With an MCA, you receive a lump sum of cash upfront, and then you pay back the advance with a percentage of your daily sales. You're essentially selling your future sales at a discount.

Merchant cash advance providers will deliver a lump-sum amount into the business owner's bank account, which is automatically paid back with a percentage of daily sales. 

Daily payment amounts will ebb and flow with sales - when sales are high, your payments are higher, and when sales are down, the payment will be lower. Approvals are based on sales more than a credit score, which can be helpful to a business that is just starting out and doesn't have an established credit history yet.

There are two terms you should be familiar with for an MCA: factor rate and holdback rate. The factor rate, which is expressed in decimal form, determines the cost of the loan and it could range anywhere between 1.1 and 1.5. If your advance is for $25,000 and you have a factor rate of 1.15, then you will owe $28,750.  The holdback rate is the percentage of sales that will automatically be held back from daily sales for repayment. The constant variance in MCA costs makes it difficult to budget week-to-week and month-to-month. Normally, when your sales go up, you'll have additional revenue to invest in other parts of the business. However, with an MCA, more sales lead to more correlated expenses-which can be a challenge to plan for in your budget.

There you have it, the best small business loans for working capital plus an MCA, one of which could make all the difference when a business is experiencing a cash crunch.

Where can small business owners get working capital loans?

Small business owners looking for working capital loans have several options for obtaining this type of financing. Here are some common sources to consider:

Traditional Banks

Many traditional banks offer working capital loans to established businesses with a strong credit history. These loans may have lower interest rates but may also require more extensive documentation and a longer approval process.

Online Lenders

Online lenders, including peer-to-peer lending platforms and alternative finance companies, provide working capital loans with faster approval times and more flexible eligibility criteria. These loans are often suitable for businesses that may not qualify for traditional bank loans.

Credit Unions

Credit unions are member-owned financial institutions that may offer competitive working capital loan options to their members. If you're a member of a credit union, it's worth exploring their loan offerings.

SBA Loans

The SBA offers various loan programs to help small businesses, including working capital loans. These loans typically come with favorable terms and lower interest rates but may require more paperwork and have longer approval times.

Online Business Lenders

There are specialized online lenders that focus exclusively on small business loans. They often provide quick access to working capital loans with straightforward application processes.

Invoice Financing

If your business has outstanding invoices from customers, you can consider invoice financing. This option allows you to borrow money against the value of your unpaid invoices, providing you with immediate cash flow.

Equipment Financing

If your working capital needs are related to acquiring specific equipment or machinery, equipment financing can be an option. This type of loan allows you to purchase equipment and repay the loan over time while still benefiting from its use.

Business Credit Cards

Using a business credit card for working capital needs can be convenient, especially for smaller expenses. However, be mindful of interest rates and try to pay off the balance promptly to avoid high-interest charges.

Microlenders

Microlenders are nonprofit organizations or community-based lenders that specialize in providing small loans to businesses, particularly those in underserved communities or specific areas of business.

Before selecting a source for your working capital loan, carefully evaluate the terms, interest rates, repayment schedules, and eligibility criteria to find the best fit for your business's specific needs. Additionally, consult with financial advisors or professionals to ensure you make an informed decision about securing working capital for your business.

Frequently Asked Questions

1. Are working capital loans a good idea?

Working capital loans can be a good idea for many businesses, especially those with short-term cash flow needs. It's vital to access your company's everyday business expenses and ability to pay interest and loan terms in the near future. Also, assess your ability to give a personal guarantee, such as collateral, to receive approval for these cash flow loans.

So, yes, depending on your situation, working capital loans can be a very good idea.

2. Is working capital loan debt?

Yes, a working capital loan is a form of debt. When you take out a working capital loan, you are borrowing money that needs to be repaid, typically with interest. It's considered a short-term debt obligation because it's intended to cover immediate operational needs. However, unlike long-term loans or business mortgages, all types of working capital loans are usually repaid over a shorter period, often within 6 to 18 months.

3. What is the difference between a working capital loan and a business loan?

The primary difference between a working capital loan and a business loan lies in their purpose and term:

  • Working Capital Loan: This type of loan is specifically designed to address short-term cash flow needs for day-to-day operations. It's often used to cover expenses like payroll, inventory restocking, or paying bills. Working capital loans typically have shorter terms and are repaid quickly, usually within a year or so.
  • Business Loan: Business loans are more general-purpose loans that can be used for various purposes, including long-term investments, expansion, equipment purchase, or debt consolidation. They come in various forms, such as term loans, SBA loans, and lines of credit, and usually have longer repayment terms that can extend for several years.

In summary, a working capital loan focuses on short-term operational needs, while a business loan can serve a broader range of purposes and typically involves longer repayment periods.

4. What is the difference between a working capital loan and an overdraft?

Working capital loans and overdraft facilities are both financial tools that help businesses manage their cash flow, but they differ in several key ways:

  • Working Capital Loan: This is a formal loan arrangement where a lender provides a specific amount of funds to a business for a predetermined purpose, often with a fixed interest rate and repayment schedule. Working capital loans are suitable for planned expenses and have a defined term.
  • Overdraft: An overdraft is a financial arrangement linked to a business bank account that allows the account balance to go below zero without causing a bounced payment. It is a form of revolving credit, and interest is typically charged only on the overdrawn amount. Overdrafts are more flexible and can cover unexpected shortfalls in cash flow, but they may have higher interest rates than working capital loans.

5. When should a business get a working capital loan?

A working capital loan is valuable for businesses in various situations. It bridges seasonal cash flow gaps, fuels growth initiatives, and covers day-to-day operational expenses. It also enables seizing unexpected opportunities, managing unforeseen costs, and funding marketing campaigns. Furthermore, it can help consolidate high-interest debt, improve creditworthiness, and optimize cash flow by capitalizing on supplier discounts.

Looking to grow and need a temporary boost? Do you anticipate needing help to pay the next few month's operational expenses? A working capital loan may be right for you.

Get started with Funding Circle

Are you eager to take your business to the next level by securing the essential working capital it needs to thrive? Look no further – embark on your journey towards financial success with Funding Circle today. Our tailored and flexible financing solutions are meticulously designed to empower and support small businesses just like yours.

At Funding Circle, we understand that small businesses are the lifeblood of our economy, and we're committed to helping you achieve your business goals. Whether you're looking to expand operations, invest in new opportunities, manage cash flow, or pursue strategic initiatives, our range of financial products can be customized to fit your unique needs.

With Funding Circle, you'll benefit from a straightforward and streamlined application process, putting the power of working capital back into your hands quickly and efficiently. Don't let financial constraints hold your business back. Get started now, and let us be your trusted partner on the path to growth. Your success is our mission.

Author
Michael Jones
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The views and opinions expressed in this article are solely those of the author writing in their individual capacity. They do not purport to reflect the views or opinions of iBusiness Funding. This content is for educational and information purposes only, and should not be taken as financial, tax, legal or HR advice. It is not intended as a substitute for professional advice. All loan offers and qualifications require credit approval and are subject to change with or without notice.

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