Working Capital Loans

Working capital loans do not refer to a specific loan product, but rather to any type of business funding used to cover day-to-day costs and short-term business needs. So how a working capital loan works depends on the financial institution that issues the money, and the borrower’s choice of financing.

For a standard small business loan, you apply with a lender (generally at a bank or online). If you’re approved, the funds will be deposited to your business bank account. From there you can use it to cover any business expense. You then repay the borrowed money (along with interest and any fees) on a regular schedule over a period of time — commonly several months or a few years.

A number of business financing options can be used to cover your working capital needs. Some of the most common types of working capital loans include the following:

Short-term business loans. Otherwise known as a business term loan, a short-term business loan is most commonly used as a working capital loan. The borrower receives a lump sum of money upfront and repays it with interest over the course of several months or years.

Business line of credit. A small business line of credit can be used as a working capital line of credit. With a line of credit, you have access to a specified credit limit from which you can draw as operational costs pop up. As you repay what you borrowed (with monthly or weekly payments), your available credit replenishes for you to draw from again — without having to reapply.

SBA loans. The Small Business Administration (SBA) doesn’t actually issue small business loans themselves. They guarantee small business loans for approved borrowers so that different loan providers can issue business funding with favorable loan terms.

Merchant cash advances. Merchant cash advances are a unique form of small business funding in which a business will sell a percentage of their future sales in exchange for an upfront lump sum of cash. These are most commonly used as short-term loans.

Invoice financing. Also known as accounts receivable financing, some financing companies will “buy” or exchange an advanced sum of money for your outstanding unpaid invoices. Companies that do this will often forward 85% of the value of the invoices, and hold the remaining 15% until the invoices are paid. The financing company will also charge a small “factor rate” for each week the invoice remains outstanding.

Trade credit. If you’re on good terms with your vendors and suppliers, it’s possible to negotiate payment terms to accommodate the seasonality of your business. Suppliers are often amenable to working with their best customers when they need to fund a large order by extending the payment terms.

Business credit cards. A business credit card is common enough that many small business owners are already using them to pay for day-to-day operational expenses. In that sense, they are already leveraged as working capital financing.

There are numerous reasons small business owners choose to borrow money, but working capital loans are generally for everyday expenses. Here are some situations where a short-term cash flow loan could make the most sense:

Seasonal cash flow. Many seasonal businesses require a little extra capital to meet operational expenses during times when their monthly revenue is known to vary. Working capital loans can be used to cover downtime or to ramp up for a busy season.

Unexpected expenses. It’s not uncommon for businesses to experience unexpected expenses like a major plumbing problem or other maintenance issues that can inhibit their daily operations.

New project startup costs. Ramping up for a new project or a new client sometimes requires borrowing money that a small business can then recoup within a few months.

Purchasing inventory at a discount. A working capital loan may allow you to take advantage of an opportunity to purchase inventory at a discount. This would lead to increased margins and higher profits for that item.

Emergency repairs to critical equipment. When equipment necessary to the operation of your business fails, it likely doesn’t make sense to wait several weeks to start repairs. A working capital loan can be a good way to start repairs right away.

If you divide the value of your current liabilities into your current assets, you’ll come up with a ratio of current assets to current liabilities. A good goal should be to have twice as many current assets as you have current liabilities (a 2:1 ratio). Anything below a 1:1 ratio means that you have negative working capital — even if you have cash in the bank at the end of the month.

For small businesses, it might make more sense to consider the formula in terms of average inventory turns. That is, the average number of days it takes for inventory to turn over, how quickly you need to pay for that inventory, and the average number of days it takes for your customers to pay you. If your customers don’t pay you fast enough to meet your financial obligations to your suppliers (or if your inventory sits on the shelf too long and ties up capital), you will have trouble meeting your capital needs out of cash flow.

All small business lenders have requirements for applicants to meet before qualifying for business funding options. These commonly include your time in business, annual revenue and personal or business credit history. The amount of paperwork and the exact documentation needed will vary from lender to lender, but commonly your business bank statements, a current profit & loss statement and/or a business balance sheet are good to have on hand. Online business lenders, such as Ondeck, will generally require less documentation. All of these factors will help to determine details such as your loan amount, repayment terms and interest rate.