How Does a Working Capital Loan Work?
As a small to medium business owner, you know the importance of having a ready-to-access fund of working capital. It’s the cash you use to pay for the everyday expenses in your business.
When your working capital is healthy, there is no problem covering payroll. Cash flow gaps will occur during the course of running your business. Having a source of working capital ready to pull from can help you prepare for and manage those gaps.
But sometimes, it can be hard to build the fund, especially when you’re in a startup period. And established businesses will have to dig into their working capital to finance expansions or unexpected costs.
Finding a Solution to a Depleting Cash Flow
Running a business always includes overhead. As cash flows in, it also flows out.
The goal, of course, is to have more inflow than outflow.
This isn’t always possible, so what do you do when your expenses dominate your working capital?
For some businesses, the solution to a temporary cash-flow issue could be a working capital loan. It’s a financing option designed to help business owners fund their daily operational costs.
What does a working capital loan include, and how does the funding work?
1. The Basics of a Working Capital Loan
As the name implies, a working capital loan is solely to fund your business expenses. Anything that is part of your daily operations is fair game for these funds.
Unlike traditional bank loans, this type of funding source is intended to be a short-term solution. You’ll have access to the loan amount quickly, but the repayment terms usually require you to pay the debt off within one year.
Although it’s possible to get approved for a working capital loan through a bank, the application process can be too long to help you out of a jam. Many small business owners turn to online lenders to speed up the steps, getting their money within one day of approval.
In general, it’s a flexible loan that gives you fast cash without a lot of paperwork and hassle. You can use it as a loan during your off-seasons, then pay it back in full when your business is booming in the peak periods.
However, as with any outside financing, experts caution against using a working capital loan as a regular crutch for your business.
2. Advantages of Working Capital Loans
Your bills won’t always wait until your bank account is flush with funds. Getting behind on credit cards and other expenses usually means you’ve just added late fees and interest to your debt.
Paying your monthly bills plus whatever you’re behind on can become a vicious cycle of robbing Peter to pay Paul. But strategic use of a working capital loan can put your business’s financial standing on a firmer foundation.
When Working Capital Loans Are a Smart Idea
Businesses in B2B sales are part of a cyclic supply chain. The money part of that flow can be tied up with the wholesaler or another retailer.
Owners in companies like these often find themselves in need of immediate cash for urgent expenses such as repairing or replacing equipment or covering overhead.
Putting rent and supplies on a credit card or getting merchant cash advances sets you up for extra monthly payments, likely with high interest rates. And if you miss a payment, it impacts your business credit rating.
When you need flexible funding, and you know you’ll be able to pay it back fast, a working capital loan can help.
These are usually unsecured loans with a lot of advantages, including:
- You don’t need to put up any collateral or personal guarantee
- The funds work similarly to a line of credit system, where you access them as needed rather than in a lump sum
- Your cash flow stays operational
- No negative impact on your credit or late fees
- You can still hire new employees and take on new business as usual without a hitch
You’re going through a rough financial patch, not a permanent dip in the accounts receivable. But you still need to cover your current liabilities. This type of funding source eliminates the need to bring in outside investors or risk serious delinquencies.
3. Getting Approved for a Working Capital Loan
Whether you’re a startup or an established business owner, getting a loan is rarely cut and dried. There’s a paperwork and approval process for all of them, and each one is different.
Working capital loans are easier than some other routes, but every potential lender has its own requirements.
What to Expect in the Approval Process
There are three main types of working capital loans:
The Small Business Administration (SBA), private loans, and bank loans.
Getting financed through each one is a little nuanced, but overall, the processes are similar.
SBA loans are backed by the United States Small Business Administration. They’re not the lender — a bank or other institution is. The SBA simply insures the risk, giving the borrower a better chance of getting approval and a lower interest rate.
The disadvantage of this type of loan is that the application paperwork can take weeks or months to complete and get approved.
If you can wait, you’ll reap the benefits of better terms than that of typical loans.
To qualify for an SBA loan, your business has to meet strict requirements, including:
- A high credit score (at least 690)
- No bankruptcies on record for the previous three years
- A down payment of at least 10% of the loan
- No criminal history
- No current federal debt
- Based in the United States as a for-profit small business
If you meet these criteria and can hold off on getting your capital for the foreseeable future, an SBA loan is your best bet.
A traditional bank loan isn’t quite as complicated as SBA financing is, but it’s still cumbersome. There’s a lot of paperwork, high standards for approval, and a long wait process.
Bank loans for working capital are intended for things like:
- Cleaning up the cash flow
- Buying essential equipment
- Expanding the business
- Covering payroll
You’ll need to have a plan for your funds, and the bank will want that plan in writing.
In addition to a business plan, banks often require you to have been in operation for at least a year with stable accounts receivable. The financial institution will look at your credit score, operational expenses, and collateral options.
They’ll also scrutinize your personal credit and history. If everything you have is in tip-top shape, and you don’t mind the wait and longer repayment terms, a bank loan may help.
Alternative lenders offer easier approval odds with private working capital loans. The higher fees and interest are offset by faster cash on hand.
Private lenders don’t need as much paperwork. You can go online, find a potential funder, and fill out a few basic details. Within minutes, you’ll know if you were approved or not. If you were, the money could be in your account within a few days.
As with the other working capital loans, lenders expect you to repay their funds in the short-term future. But with the higher interest rates, make sure you can afford the monthly payments that will require.
4. Things to Know Before You Choose This Financing Route
Borrowing money doesn’t have to be a struggle. If you are cautious about what you’re getting into and use the funds well, it can be the springboard to a better financial situation for your business.
Before you leap at the first lender that approves you, there are a few things to be aware of, though.
Most loans, including the working capital kinds, will offer lower interest rates if you put up some form of collateral. Private lenders don’t require security, meaning you’ll have higher interest rates. But if you do put collateral down and can’t repay the loan, it could cost you your current assets.
Any new loan will impact your credit score, affecting it for the life of the loan. Until you pay the financing, your score may take a hit.
5. Alternatives to a Working Capital Loan
When it comes to small business loans, you do have options.
Depending on your business’s needs and how it’s run, one of these alternatives to a working capital loan might be better for you:
Bank Line of Credit
Like a credit card, a business line of credit gives you access to a pool of money. You dip into it as needed and pay interest on only the borrowed funds.
However, as with a traditional loan, the approval process can be time-consuming and complicated.
Easier to qualify for than a bank loan, short-term loans are often through private lenders.
Apply online with a quick approval process and get your money fast. The downside is you’ll also likely have hefty fees and a high-interest rate to repay.
Equity Funding/Outside Investors
Selling shares in your business lets you raise money through equity funding and outside investors.
When you need a lot of capital in order to stay afloat or expand, this type of financing is an idea. Remember, you are selling part of the ownership of your company to other people — don’t make this decision lightly.
Accounts Receivable Loans
This alternative solution, also called AR financing, is when a business receives money that’s owed to them but they haven’t yet managed to collect.
The lender uses the accounts receivable as collateral, advancing the owner for cash owed minus a fee.
Accelerated invoicing through Now lets you collect immediately for outstanding invoices.
Unlike a loan or invoice factoring, Now charges a small one-time fee per invoice. There’s no change to your liability or personal guarantee. Now pays you what you’re owed, then collects the amount due from the client. It’s the perfect solution for businesses that don’t want to impact their credit history or add debt to their balance sheet.
No matter which financial solution you choose, review all the fine print and loan terms. Pick the one you qualify for that also has the most advantages, and use it to get back on track.
See also: How to Keep Track of Payments Received
Getting approved for working capital financing or other business financing doesn’t have to be complicated or scary.
With this guide, you have all the information you need to make an informed choice on the best loan options that will help your business meet its goals.
Create your NowAccount today to see if you qualify for accelerated invoice payments!