According to data by the Federal Reserve, 40% of businesses have a hard time paying their operational expenses. For such business, failure to access working capital financing can lead to low or no investment in other critical operational areas for growth.
Every business eventually finds itself against a wall of constrained growth due to working capital issues. In many cases, owners who can’t find ways to inject external funds to support their working capital risk the loss of their business.
Here’s an in-depth look at what working capital loans are, how to get them, and how they work to help you manage your operational expenses.
What’s a Working Capital Loan?
Working capital is the resources a business utilizes in its day-to-day activities, excluding cash. To get your working capital, you subtract current liabilities from the firm’s current assets.
As such, a working capital loan is a credit facility businesses take out to finance their daily operations. Examples of such operational needs include payroll, rent, and debt payments, among others.
When you’re sourcing a working capital loan, you’re looking to meet the company’s short term needs operationally.
Standard Business Loan Versus Working Capital Loan
You must not confuse regular business loans with a working capital loan as that can obfuscate the latter’s usefulness. A traditional business loan is credit you get to purchase something specific; that could be a car or even a building for the business. When you’re taking out business capital, the loan is secured by the asset you plan to purchase. If you fail to pay the loan back, the lender can sell the asset to recover their money.
A working capital loan, on the other hand, is not taken out against any collateral; such a loan can be in the form of a business line of credit that you draw from when the need arises.
How a Working Capital Loan Works
Since a working capital loan is short term in nature — that is, not more than 12 months — it’s important to understand its unique interest rate.
Typically, the total amount you pay back on a working capital loan is around 1.2 to 1.5 times what you borrow. In addition, a working capital loan is paid back on a weekly or daily schedule, depending on what you agree with the lender. But remember that this is a loan with a short period meaning that the annual percentage rate (APR) is going to look higher than for other longer-term loans.
For example, let’s say you take out a working capital loan of $25,000. If you’re paying back around 1.2 times in total, that comes to $29,997. Over a weekly payment lasting 12 months, such a loan can boil down to an APR of around 37%.
Many entrepreneurs get sticker shock when they first source a working capital loan due to the interest rate — but as long as you equate the interest rate to the nature of the loan, you should be able to identify good deals. The bottom line is that if you’re assessing a working capital loan, focus on the total payments you’ll need to make. How much you want to borrow versus what you’ll need to pay back is the best way to analyze a working capital loan.
Advantages of a Working Capital Loan
If you need to tap external funding for working capital, there are several reasons why a working capital loan is the best option.
Quick Access. In many instances, applying for a working capital loan is a process that takes less time than seeking a traditional loan. When you’re facing an unexpected crunch in managing your working capital, that speed can mean the difference between survival and implosion for your business.
No Collateral. A working capital loan, in most cases, won’t require you to pledge security for it as it’s unsecured. That gives you peace of mind as your business assets stay free of encumbrances, unlike with a standard business loan.
You Retain Ownership. A working capital loan won’t require you to part with equity in your business to get the funding you need. That’s in stark contrast to when you bring in an equity partner to inject capital into the company that you can use to support your working capital. Such a loan keeps you in control of the firm, with your only commitment being to repay the credit.
Meet Short Term Needs. The flexibility of a working capital loan concerning repayment tenors and access helps you deal with short term needs as they arise.
Types of Working Capital Loans
The kind of working capital loan you need will depend on what your business dictates. Therefore, you need to match these dictates to several options in today’s credit market if you’re to spy out the best option.
Some of the most common options you can look at include:
Invoice Financing. Invoice financing is where you use your outstanding invoices as collateral to secure funding. For many businesses, especially in the B2B area, slow-paying clients can cause the cash flow to dry up. However, since you made sales and are to collect on them, you can trade-in your invoices for an agreed amount with a lender, less their lending fee. Doing so helps you turn accounts receivables into cash, which can then prop up your working capital engine.
Small Business Administration Loans. The Small Business Administration (SBA) is an entity of the federal government that helps businesses secure various types of funding. Their 7(a) loan program is especially popular among entrepreneurs as it’s a multi-purpose loan facility that businesses can deploy in various ways. Through this program, you can apply for a working capital loan, and the SBA will guarantee a portion of it. As a result, any collateral deficiency you may have won’t be a stumbling block to you receiving your finances at a low cost. Keep in mind though that SBA loans are government-backed, and that means that the process will take longer. The longer-term lengths and low rates on these loans, however, do make the lengthy application process worthwhile.
Business Lines of Credit. A business line of credit is where you receive a revolving facility worth a certain amount. You can draw from this facility as need arises until you exhaust the maximum amount. Since the facility is revolving in nature, it means that you can repay and keep borrowing until you hit the limit. A line of credit for working capital is a helpful way to get more consistent cash flow. The facility is especially beneficial in that you don’t need to acquire another loan to continue supporting your working capital. As long as you pay down a portion of what you borrow, you can keep drawing from it. If you aren’t sure exactly how much working capital you’ll need, then a line of credit is the right fit. You can also use a line of credit to create a cushion against unexpected demands on your working capital, even if you have adequate internal funds to support working capital under normal conditions.
Short-Term Loans. A short-term loan — also known as a fixed-term or cash flow loan — is a facility that’s issued to you in one lump sum. You then begin paying it back in regular, fixed installments over a short period. The main difference between short term and installment loans is that you pay a fixed fee in place of interest charges. A short-term loan is excellent for working capital if you need to source funds for a brief period. You won’t be stuck paying back the loan over many years, and it’s easier to qualify for due to its short tenor. If you’re a young business, a short-term loan is especially effective in dealing with burgeoning working capital needs before you can qualify for installment loans.
Installment Loans. An installment loan — also known as a term loan — is issued to you in a lump sum. When you start repaying it, you’ll be covering the principal plus the interest in regular, fixed installments. These loans mostly apply to established businesses as they have the track record to leverage them for working capital.
Trade Credit. Sometimes all you need for your working capital to stabilize is to receive goods on credit. Trade credit is where manufactures and other types of businesses advance products to an off-taker without requiring upfront payment.
Trade credit typically spans seven, 30, 60, 90, or 120 days depending on your agreement. Once the credit period expires and you haven’t settled the loan, you’ll likely pay interest.
Keep Your Operations Going
Working capital is the lifeblood of your operations, and as such, you need to keep that engine running. When you face constraints in your cash flow that adversely impact your operational spending, working capital loans can come to your aid. So make sure you map your businesses’ unique working capital needs to match them to the right credit option for you.
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