Working capital loans can help pick up the slack during an off season or when you just need a little boost to help your business grow. They’re typically friendlier to small and new businesses than your average bank loan, and you won’t have to borrow a huge amount to qualify.
This doesn’t mean they don’t have downsides, but if your business is having some minor cash flow issues, then a working capital loan could help.
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What is a working capital loan?
A working capital loan is a business loan used to cover the day-to-day expenses of a business, rather than long-term purchases like equipment or real estate. Business owners often use working capital loans to buy inventory, cover payroll or get an advance on unpaid invoices.
Working capital loans can be particularly helpful for seasonal businesses while profits are low. They typically come in smaller amounts than traditional business loans, have shorter terms and are easier for a small business to qualify for.
Working capital loans can include:
Merchant cash advances. Basically an advance on a business’s future sales. Businesses receive a lump sum, which they repay with a percentage of each sale (usually credit card sales) until they’ve paid off their loan.
Invoice financing. An advance on a business’s unpaid invoices, in which the business repays as customers pay off their invoices, plus a fee — usually around 3% of each invoice’s value.
Invoice factoring. A one-time deal where businesses sell unpaid invoices to a third party at a slightly lower value than they’re worth — typically around 85% to 90%.
Short-term business loans. Fixed-term loans available in smaller amounts than your typical business loan — usually starting at around $2,000 rather than $25,000. You usually have 6 months up to a few years to pay it off.
Business Development Bank of Canada (BDC) Working capital loans. Issued by Canada’s only financial institution devoted exclusively to entrepreneurs, the BDC working capital loan can be used to cover daily expenses, take advantage of bulk discounts from suppliers or as a complement to your business line of credit. Your personal assets are never used as collateral, and repayment terms are flexible to match your cashflow patterns.
What exactly is working capital?
Working capital is the amount of money a business has access to for short-term business needs. To calculate your business’s working capital, add up all of its liquid assets —such as cash and accounts receivables — and subtract its liabilities — meaning, debts.
How to calculate working capital
Working capital = money your business has access to (or is owed) – the amount of debt your business owes
A business with a positive amount of working capital can generally afford to take on more debts, has a financial cushion in case of emergencies and often earns more than it spends — though it might not always have direct access to that cash. Businesses with negative working capital might want to reconsider taking out a new loan and turn to alternatives like crowdfunding or finding investors.
How should I keep track of my working capital?
Knowing the state of your working capital is the same as running any other part of your business: monitor your metrics and keep track of fluctuations. You can do this by:
Keeping track of your liabilities. Your liabilities include debt and any regular obligations like bills and rent.
Keeping track of your assets. Your assets may change often, but in general it will include any inventory you have in stock, your accounts that haven’t been paid and any cash you may have on hand.
Repaying your working capital loan
The repayment terms will depend on a number of factors including:
The lender you chose. Different lenders will offer loan terms based on their criteria and risk assessment of your business. Some lenders may require repayment as a fixed percentage of your daily sales.
Loan collateral. A secured loan will likely have a longer repayment period than an unsecured loan. Consider backing the loan with your assets, like land or real estate, if you want to lock in a longer repayment period.
Why might I consider a working capital loan for my business?
Can help seasonal businesses stay afloat. You know your business will start to make enough in a few months to start turning a profit, but that won’t help you with your expenses today. A working capital loan can help keep you from folding during the off season.
Available in small amounts. Small businesses typically don’t need hundreds of thousands of dollars to cover daily expenses. Working capital loans can give your business the exact amount of funding it needs.
Easy for small businesses to qualify. Small businesses can sometimes have trouble meeting revenue requirements that come with larger-dollar loans. That’s less of a problem with working capital loans, which are typically smaller.
Quick funding. Depending on your lender, you can get financing as fast as the next business day.
You may not need collateral. Many working capital loans don’t require you to put anything on the line that your lender can seize if you fail to pay it back. Although, the drawback of unsecured loans is that they often have higher interest rates than those secured with collateral.
Prep for emergencies. A business line of credit can be a helpful way of enhancing your working capital on a day-to-day basis, but if you’re faced with an emergency, the flexibility of a credit line may be just what you need to stave off large expenses.
Take advantage of new opportunities. With a working capital loan, you can quickly jump on new opportunities to expand your business. As long as your business can handle the payments, you won’t have to worry about losing your competitive edge just because your business lacks the immediate finances to act.
What are the disadvantages of taking out a working capital loan?
It likely can’t fix a failing business. Businesses that have persistent financial problems might want to look into other options before taking on more debt. If you’ve had a steady downward trend in your business’s revenue, taking out a loan could make the situation worse.
Potentially high rates. Many working capital loans are intended for the short-term and come with smaller amounts. Because they won’t turn as big of a profit for the lender, you may be charged higher rates than you would with a standard term business loan.
It often needs to be repaid quickly. Aside from coming with higher rates, it can sometimes be difficult for businesses to afford repaying a working capital loan if profits take a brief dive – especially because some come with weekly or even daily repayment schedules.
Your personal credit counts. Lenders often consider a business owner’s credit score and history when they apply for a working capital loan. They sometimes require business owners to put a lien on their personal assets in case the business can’t afford to pay back the loan.
How do I know how much working capital my business needs?
You can measure your working capital needs by calculating your “working capital ratio,” which measures your business’s ability to use its assets to pay for its liabilities.
Calculate working capital ratio by:
Working capital ratio = business assets ÷ business liabilities
Generally, you’ll be looking for a working capital ratio between 1.0 and 2.0 — anything lower or higher than this might indicate your business isn’t running as efficiently as it could.
A number lower than 1.0 means you have more liabilities than assets. For example, if you only have $50,000 in assets but are paying out $55,000 toward your debts, you have a working capital ratio of 0.91. Working in the red like this is risky and often results in a business going under.
On the other hand, a working capital ratio of about 2.0 means you’re not investing back into your business enough. If you have $50,000 in assets but are only paying $25,000 toward your liabilities, you have a working capital ratio of 2.50 and may want to consider ways to expand your operations.
Find a working capital solution that keeps your liabilities to a minimum while increasing your ability to utilize your liquid assets.
What is working capital liquidity?
Working capital liquidity is the speed you can sell or buy an asset or piece of security. While you may have assets that keep your business in the black, the reality is not all of this is liquid. Your inventory and accounts receivable are much less liquid than cash — you’ll need to sell inventory or collect on unpaid invoices in order to use the money as working capital.
How to make the most of a working capital loan
Have a method for spending. Consider first paying off your immediate expenses, like utility bills, rent and debt repayments before using it for less-urgent but still important purchases like expanding your inventory or technology upgrades.
Spend at strategic times. Try to avoid draining your business’s account before a repayment is due to avoid late or insufficient funds fees.
Set up autopay. Most lenders require borrowers to use automatic loan repayments and some give a discounted rate for autopay borrowers — typically around 0.25%.
Repay your loan early. One of the best ways to save on the cost of your loan is to repay it as quickly as possible, provided there isn’t an early prepayment penalty.
Bottom line
Working capital loans can be a big help to small businesses that have money coming in but could use some extra cash to maintain daily operations. It can be especially helpful for seasonal businesses that need a little help making it through slower months. But if you’re looking to finance a big project or add a location, you might want to check out other business loans like equipment loans, commercial loans for real estate or other business term loans.
Not sure if a working capital loan is right for you? Our business loans guide is a starting point when you need to determine what type of loan will suit your business.
Frequently asked questions
Working capital is your business’s total liquid assets. Liquid assets include cash, money it’s owed, certain types of bonds and anything else that you can quickly cash in. Cash flow is the amount of money coming in and out, not other assets.
You can generally get better rates and have an easier time qualifying for a working capital loan if you have a strong personal credit score. But keep in mind that lenders also consider factors like how long you’ve been in business, how much money it makes each month and how much money you’re asking to borrow when considering your application.
Both working capital loans and term loans involve borrowing a fixed amount of money all at once and paying it back. In fact, some working capital loans are actually term loans, but for smaller amounts with shorter terms.
Other working capital loans that involve an advance on either sales or invoices don’t come with a fixed amount of time that you have to repay your loan. Instead, how long it takes to repay your loan depends on how much you make or how quickly you can get payments on your invoices.
Anna Serio is a lead editor at Finder, specializing in consumer and business financing. A trusted lending expert and former certified commercial loan officer, Anna's written and edited more than 1,000 articles on Finder to help Americans strengthen their financial literacy. Her expertise and analysis on personal, student, business and car loans has been featured in publications like Business Insider, CNBC and Nasdaq, and has appeared on NBC and KADN. Anna holds an MA in Middle Eastern studies from the American University of Beirut and a BA in Creative Writing from Macaulay Honors College at Hunter College, CUNY.
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