As a small business owner, you’ll likely face both exciting and challenging times along the way. When all is well in your world, staying motivated and taking strides toward growing your company is easy. But how about when the latter happens? If financial woes are the culprit, it can be tempting to throw in the towel if you can’t find the funding you need.
Fortunately, working capital loans exist to help you keep operations afloat. Here’s what to know about this funding source, along with the pros and cons and how to decide if it’s a good fit for your business.
What Are Working Capital Loans and How Do They Work?
Working capital loans are a type of short-term business loan designed to help your business cover regular expenses. These loans ensure that you have enough cash on hand to pay for operating costs, such as payroll, rent, and inventory. They are often provided by banks, but online lenders have become increasingly popular in recent years, offering quicker funding and convenient application processes.
When you apply for a working capital loan, lenders will evaluate your company’s financial health, operational history and growth potential to determine whether you are a suitable candidate for the loan.
Upon approval, you receive a lump sum of cash that you can use to cover your day-to-day business expenses. Your loan term will dictate the time frame in which you need to repay the loan. Different lenders offer various repayment options, so choosing one that aligns with your business’s cash flow is essential.
Approval times can vary – traditional banks may take a few weeks, while online lenders can potentially approve your loan in a matter of days.
Why Do Businesses Get Working Capital Loans?
As a business owner, you may encounter situations that require quick access to funds, and working capital loans can offer the solution. They could include cash flow fluctuations, short-term cash flow gaps and outstanding receivables. In any of these cases, you may need a capital infusion to cover operational expenses, like payroll and rent, or to invest in inventory to keep your business up and running.
Types of Working Capital Loans
There are several types of working capital loans available, each with its own benefits and drawbacks. Here are some options to be aware of:
- Term Loans: Traditional term loans provide a lump sum of cash upfront, which you repay over a set period. Term loans come in various forms, such as secured or unsecured, short-term or long-term, and come with fixed or variable interest rates.
- Lines of Credit: Business lines of credit give you access to a specified amount of funding, which you can draw on as needed. Like credit cards, you can borrow and repay funds as needed, with interest charged only on the amount you use.
- Business Credit Cards: Another working capital option for short-term financing is business credit cards. They provide quick access to funds for various business expenses, and some feature cashback rewards and other perks. The downside is they often have steep interest rates, so paying off your balance sooner rather than later is vital.
- Invoice Financing: If your business often faces cash flow issues due to unpaid invoices, invoice financing might be an ideal solution. With this type of loan, you sell your outstanding invoices to a lender, who advances you a percentage of the invoice value. Once your customer pays the invoice, the lender receives the full amount minus a fee. It is ideal for small business owners who don’t apply for traditional forms of financing.
- Merchant Cash Advances: A merchant cash advance (MCA) is an advance based on your expected credit card or debit card sales. In this case, the lender provides an upfront cash amount, and you repay the advance by providing a percentage of your future card sales. Similar to invoice financing, MCAs can provide fast access to funds, but they often come with higher costs and less favorable repayment terms than other working capital loans.
What Are the Advantages of Working Capital Loans?
You’ll find that there are many upsides to securing a working capital loan for your small business.
Enhanced Cash Flow
Working capital loans can significantly improve your business’s cash flow. By having access to additional funds, you can maintain operations and avoid potential financial hiccups. Plus, a healthy cash flow is key to the success and growth of your business.
Fast and Easy to Secure
The application process for these loans is typically quicker and more straightforward compared to traditional bank loans. And the funding times are also much shorter – sometimes, as soon as the next business day compared to several days or weeks. This means your business can obtain the necessary funds in a timely manner, allowing you to capitalize on opportunities or address urgent needs.
Easier to Qualify For
Banks and credit unions often have stringent requirements regarding credit scores and financial history. However, working capital loans may have more relaxed criteria – particularly those from online lenders – making it a viable option for small businesses with less-than-perfect credit scores.
May Not Require Equity or Collateral
Depending on the lender and loan type, working capital loans may not require you to offer equity or collateral to secure the loan. This can be particularly beneficial for small businesses and startups that lack assets to use as collateral. Keep in mind that interest rates may be higher for unsecured loans.
Flexibility and Control of Funds
Working capital loans offer flexibility and control over how you use the funds. Unlike traditional loans specifically designated for particular expenses, like equipment or real estate loans, working capital loans can be used for a wide range of purposes to support your business operations.
What Are the Disadvantages of Working Capital Loans?
Unfortunately, there are also downsides to consider when deciding if a working capital loan makes sense for your business.
Potentially High-Interest Rates
Since these loans are generally short-term, lenders might charge higher rates to compensate for the elevated risks associated with short-term lending. This could mean steeper and possibly unaffordable monthly payments for you.
Lower Loan Amounts
Another downside of working capital loans is that they typically provide smaller amounts of funding compared to long-term loans. So, they may not be suitable to cover major expenses or investments.
Shorter Repayment Terms
Depending on the lender and loan type, the repayment period could be as short as a few months. This means you will need to pay the loan quickly and could strain your company’s finances if the monthly payment amounts are unaffordable.
Risk of Over-Borrowing
Since these financing options are readily available and offer fast funding, some business owners may become reliant on them to cover ongoing expenses, which can lead to a cycle of debt. However, over-dependence can ultimately harm your company’s financial health. So, you should only borrow what your business needs and can comfortably afford to repay.
Considerations Before Getting a Working Capital Loan
If you’re sold on the idea of getting a working capital loan, below are some factors to assess prior to researching loan options and formally applying.
Assessing Your Business Needs
Ask yourself if the loan is truly necessary for your company’s survival or growth. Also, consider any short-term expenses your company has. Remember, a working capital loan is suitable for covering these day-to-day operational costs and bridging cash flow gaps. However, if the loan is for long-term investments, other financing options might be a better fit.
Studying Your Financials
Examine your cash flow, debt-to-equity ratio, and credit score, as these factors can influence your ability to secure a loan. Here’s a quick overview of each:
- Cash flow: Your business must generate a sufficient cash flow to cover the loan payments. Ensure that your cash flow projections are realistic and attainable.
- Debt-to-equity ratio: It is the proportion of your company’s debt to its equity. A high debt-to-equity ratio indicates that your business relies heavily on debt financing, which may make lenders hesitant to approve your loan application. Aim for a healthy balance between debt and equity to improve your chances of securing a working capital loan.
- Credit score: A good credit score is vital for obtaining favorable loan terms. Work on improving your credit score by paying bills on time, reducing outstanding debts and limiting credit inquiries before applying.
Weighing Out the Pros and Cons
Finally, carefully weigh the pros and cons of working capital loans. Reference the list of important considerations above before moving forward.
Are Working Capital Loans a Good Idea?
Still undecided if you should apply for a working capital loan? Here’s how to decide if it’s a smart financial move.
When Is It a Good Idea to Take a Working Capital Loan?
If your business is facing short-term challenges, such as fluctuating cash flow or seasonal demands, a working capital loan can be helpful. Furthermore, obtaining a working capital loan can help maintain business operations and even support growth initiatives, such as expanding inventory or hiring additional staff.
When Is It Not a Good Idea to Take a Working Capital Loan?
While a working capital loan can be beneficial in specific situations, it’s important to consider the potential downsides. Alternative forms of financing could be ideal if you have long-term funding needs or only qualify for steep interest rates due to credit issues.