Financial Guides

Understanding working capital loans for small businesses

If you’re a small business owner you might have wondered what a working capital loan entails. Check out our article below for our run down on how to navigate these loans.

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Whether you’re setting up a startup or running an established enterprise, you will need money to finance the company’s business needs. These include common operational costs like payroll, rent, insurance, office supplies, travel expenses, utilities, advertising and so on.

One way of meeting the day-to-day business expenses is using a working capital loan. This type of business financing is particularly helpful when you need to cover operating expenses and free up funds for expanding the business.

But before you take up a working capital loan, it’s important to understand what it is and how it may impact your business. In this article, we outline everything that small business owners need to know about working capital finance.

Key takeaways

  • A working capital loan is a credit facility that business owners borrow in order to fund day-to-day activities of their companies.
  • There are several types of working capital loans to choose from. They include SBA working capital loans, term loans, business lines of credit, invoice financing, and trade credits.
  • While trade credits and invoice financing are easier to qualify for, SBA loans offer the highest maximum amount that you can borrow.
  • A working capital loan makes sense if your business’s current ratio is lower than 1.

What is a working capital loan?

A working capital loan is a type of business loan that’s usually used to fund day-to-day costs like operational expenses, payroll and rent. It’s also common for business owners to turn to working capital finance when there are cash flow gaps. This may happen, for example, to cyclical businesses that experience off-seasons. The resultant debt can be paid down or paid off during the busy season.

Compared to other options like traditional bank term loans, working capital loans are usually flexible. This makes them ideal for covering immediate and short-term expenses. However, they may not be ideal for funding high-value projects like a business expansion. Instead, working capital financing may help by freeing up funds that you can then use to expand your business.

With that in mind, when should small business owners consider taking out a working capital loan? Generally, you may look into working capital financing if your business is struggling to meet daily operational costs. Some specific scenarios include:

  • The business has unpaid invoices, yet needs immediate money to pay for daily operations like rent and payroll.
  • When sales are cyclical and the business needs to cover operational expenses before the peak season comes around.
  • Production costs are high and finances are tight. A working capital loan can help with the creation of stock, which you can later sell to earn revenue.

While some banks and credit unions offer working capital loans, the main providers are online and alternative lenders. In addition to a streamlined application process, these financial institutions typically have relaxed eligibility requirements and good repayment terms. You can qualify even if your credit score is on the lower side.

Generally, alternative and online lenders require a personal credit score of about 5301, which makes working capital loans ideal for small business and startup owners who haven’t had the chance to build their credit.

What are the types of working capital loans?

There are several types of business working capital loans. The most common are SBA loans, term loans, business lines of credit, invoice financing and trade credit. Ideally, you’ll want to choose loan options that fit your working capital needs, yet your business can qualify for.

For example, while SBA loans and term loans have fairly strict eligibility criteria, invoice factoring and trade credit are comparatively easier to get. You can qualify for the latter two even if you have bad personal credit. Here’s a detailed dive into the various financing options for small business owners who are looking for working capital loans.

SBA loans

SBA working capital loans are partially backed by the U.S. Small Business Administration (SBA) and issued by designated lenders – usually banks and credit unions. These small business loans are meant to help small business owners start, run and/or grow their companies. For this reason, they are ideal for startups as well as existing small businesses.

One good thing about SBA loans is that they come in various types. Each type has its set of qualification requirements, repayment terms, and maximum loan amount. Understanding the various SBA financing options may help you choose the best product for your small business.

  • SBA 7(a) loan. This is a working capital loan of up to $5 million. That said, you can also use the SBA 7 to acquire real estate or refinance an existing business debt. Current SBA 7 interest rates range from 2.25% all through 8%2, which makes it one of the most affordable working capital loans. With repayment terms of up to 10 years, it’s a good pick when you don’t want to put a strain on your business cash flow.

However, the SBA 7(a) working capital loan has fairly strict minimum eligibility requirements. For one, lenders typically require a personal credit score of 680. You may also be asked to front a down payment of 10% to 20% (more if your business is a startup), some collateral and a personal guarantee2.

  • SBA microloan. This is primarily a short-term working capital loan that maxes out at $50,000. You can use the proceeds as working capital or for purchasing equipment and machinery.

SBA microloan interest rates fall in the 6% to 9% bracket. Although lending terms are slightly relaxed compared to SBA 7 loans, you’ll still need a personal credit score of 640 and above to qualify for an SBA microloan. Some lenders also require collateral in addition to a personal guarantee.

  • SBA CAPLine. This is a small business line of credit that you can use on a revolving basis. It’s meant to support seasonal or short-term working capital needs. With repayment terms of up to 10 years, the SBA CAPLine line of credit is quite friendly to cash flow. It’s affordable too; interest rates dip as low as 2.25%2. The maximum amount you can get with this line of credit is $5 million.

Term loans

A term loan is generally any type of financing that must be paid back over a set period of time. In the case of working capital financing, the loan is usually short-term and has a repayment period of anywhere from a few months to two years. It’s often provided by banks, credit unions, online lenders and alternative lenders.

Short-term loans typically max out at $500,000 and have interest rates that range from 6% to 99%1. The exact lending terms – including the rate you’ll get – will depend on your creditworthiness. If your credit history is good or excellent, you may qualify for a lower interest rate and longer repayment period.

But if you have a checkered or bad credit history, then the lender is likely to minimize risk on their part by slapping a higher interest rate on the loan. They may also ask for a personal guarantee and/or collateral.

Business line of credit

A business line of credit is a revolving loan that you draw upon whenever your business needs cash. Rather than getting a lump sum of money, you get access to a fund that you can tap into to cover working capital needs.

Perhaps the biggest benefit of a working capital line of credit is that you only pay interest on the amount you actually use. This is different from other types of working capital loans (like SBA loans and term loans), which require you to pay interest whether you use the money or not.

Maximum credit line limits typically range from $2,000 through $250,000. Interest rates will vary depending on your creditworthiness, revenue and years in business. However, you can expect an annual percentage rate (APR) of anywhere between 10% and 99%.

Invoice financing

Also known as invoice factoring, invoice financing is the process of selling your business’s unpaid invoices to a third-party company (usually called the factoring company). In exchange, the factoring company gives you a credit facility that’s around 85% to 95% of the total value of your unpaid invoices.

In other words, you’re selling your company’s accounts receivable. The factoring company is then responsible for chasing down the debtors whose invoices you sold. All the money from those debtors – including factoring fees – goes to the factoring company.

Invoice financing is a good way to raise working capital because oftentimes you’ll get the money with little to no hassle. The invoices serve as collateral for the loan, which makes it a self-secured loan. For this reason, lenders typically don’t check credit when granting invoice financing loans.

Additionally, the application process for invoice factoring is usually short and streamlined, making it one of the quickest ways of getting working capital. It’s especially a viable option if you frequently find yourself with lots of unpaid invoices. Good lenders typically have overall interest rates that range between 15% and 35%. Ideally, repayment terms should be until your debtor pays the invoice.

Trade credit

A trade credit is a type of loan issued by suppliers. Your vendor basically allows you to purchase goods on credit and pay for them at a later date. This is a working capital loan because it allows you to acquire things like inventory without having to pay for them upfront.

Access to trade credits mostly boils down to whether or not you have a good relationship with your suppliers and vendors. Some of them will check your credit history to see if you handle other business debts diligently. The better you are at managing debt, the less risky you are as a borrower and the higher your chances of getting trade credits.

Depending on your relationship with the vendor, they may give you 30, 60 or 90 days to pay back the debt. Whatever the case, trade credits can be lifesavers during the low season or when you need to free up cash for entering larger contracts.

How is a working capital loan amount determined?

Ideally, a working capital loan amount should be a value that can result in a 2:1 current ratio. This may sound like accounting jargon (and it is), but it’s the best possible way to determine how much loan your business needs. Otherwise, you may end up borrowing too much or too little. Either option is not ideal.

If you borrow too much, your business will be forced to pay interest on a large amount of money that it didn’t need to start with. This will affect cash flow and profitability. If you borrow too little, you may not be able to achieve a 2:1 current ratio.

A low current ratio (a ratio of 1 or lower) essentially means that the business doesn’t have enough liquidity to pay its debts and liabilities. You risk defaulting on payments. In fact, if your current ratio is lower than 1, it means that your working capital is negative.

From an accounting perspective, working capital is what you get when you deduct current liabilities from current assets.

Working capital = current assets – current liabilities

If, for example, your company has $180,000 total current assets and $80,000 total current liabilities, then your working capital is $100,000 (calculated as $180,000 - $80,000). This also means that your current ratio is 2¼:1.

Current ratio = current assets / current liabilities

Thus,

Current ratio = 180,000 / 80,000 = 2.25 or 2¼.

As already mentioned, the ideal current ratio is 2:1, which means that the 2.25 above is within the acceptable range. But if your current ratio is lower than 2:1 (especially if it’s close to or lower than 1:1) then you may need to borrow a working capital loan until you up the ratio to about 2:1. Your current ratio is what will tell you how much money you need to borrow.

Say, for example, that your current ratio is 0.75 (i.e., ¾:1). That means your company doesn’t have enough liquidity (current assets) to meet its debts and liabilities. It is running on a negative working capital. Consequently, you may have to borrow a working capital loan to bring the current ratio to 2:1.

Further, assume that your current assets are $75,000 and your current liabilities are $100,000. The ideal amount you’ll have to borrow is $125,000. That will push your total current assets to $200,000. And with total current liabilities of $100,000, your new current ratio will be 2:1.

While a current ratio of 2 is ideal, you don’t always have to achieve it. However, it’s important that the value doesn’t drop to 1 or lower. Anything in the 1.5 region is okay, but the goal should always be to hit a 2:1 current ratio.

Is a working capital loan a good idea for my business?

Working capital financing makes sense if your business needs to cover a short-term gap in cash flow. For example, it may be a good idea to borrow this type of loan if you run a cyclical business that needs some external cash injection during the low season. Similarly, you can use a working capital loan as bridge financing for inventory as you wait for a bigger loan (like a traditional bank term loan).

The loan may be especially necessary if your financials indicate a negative working capital. You can find this out by calculating the business’s current ratio. If it’s below 1, then it means you have fewer current assets than current liabilities. One way of correcting such a situation is by borrowing a working capital loan.

That said, if your current revenue can’t support the monthly payments that come with a working capital loan, then perhaps it may be a better idea to consider alternative sources of business funding, including a personal loan or business credit cards. The last thing you want is to take up a loan that will put even more strain on your cash flow and liquidity.

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