About Working Capital Loans
“Working Capital” refers to the cash a business has on hand to fund daily operations like payroll, inventory, accounts payable and the like. Essentially it is the cash (capital) that a business has to run its daily operations (work).
Companies sometimes seek a business loan to help fund working capital when they have a cash flow crunch… i.e. more money needing to go out than is currently coming in. There can be several legitimate reasons for this:
Seasonal business – when a business slows down or significantly ramps up 2-3 months of the year due to cyclical sales cycles.
Bulk inventory purchases – sometimes a business can receive a larger discount for buying in bulk from a supplier but they just don’t have the cash on hand that is needed. In some cases the cost of obtaining a working capital loan can often be offset by the discount for placing a larger order.
Payroll increases – hiring new staff can be expensive and it can take several months to recoup the cost of hiring and training someone.
Working capital loans are useful for helping out many short-term cash flow needs. However, if a cash flow challenge is the result of steadily declining business, cash mismanagement or some other reason then taking out a loan can exacerbate the situation. It’s important to understand what is causing the cash flow challenge before taking a business loan.
Types of Working Capital Loans
Business loans that provide working capital to your business are not always called “working capital loans.” There are actually several types of business loans that function to help a business with cash flow. These include:
Lines of Credit – typically obtained by a bank but there are other sources as well
Short Term Loan – simply a “term loan” that has a short duration where a business loan is paid back in months not years
Accounts Receivable Loan – can also be referred to as Factoring, Bridge Loan, and AR Financing where you are selling your customer invoices at a discount to receive funds now versus waiting on customers to pay you later
Merchant Cash Advance – for businesses whose customers pay by credit card you can obtain an advance against future credit card sales
Benefits of a Working Capital Loan
Speed – In general working capital loans offer a much faster application process allowing you to go from application to funding in days versus weeks or months as with other types of business loans.
Flexibility – Since working capital loans by definition are being used to fund your business’ operations, the funds are deposited directly into your business account with no restrictions on how the funds must be used (as long as its for the business and not personal use).
Short-Term – Working capital loans are meant to solve a short term cash crunch and are meant to be paid back in a short amount of time – months not years. The advantage here is that your business avoids long term payment commitments.
Drawbacks of Working Capital Loans
Interest Rate – Working capital loans carry a higher risk to the lender. That increased risk translates into a higher interest rate than say the rate you would pay to purchase a vehicle, real estate, or some other type of tangible asset that could be repossessed and resold if the loan is not paid back.
Blanket Lien – Since there is no specific asset being pledged for the loan, lenders often file a “blanket lien” on your business. This means that the lender has a security interest in all the company’s assets while the loan is in place. If you obtain such a loan it is critical to ensure the blanket lien is released when your loan is paid off to avoid delays with closing on any future business loan needs you may have.
Short Repayment Structure – Since working capital loans are paid back in months not years the payments can be high. For example, if you borrow $100,000 and pay it back over 12 months you are looking at paying $8,333 a month in principal alone. It is important to make sure that your business can handle the payment plan. The last thing you want to do is solve one cash flow challenge only to create another.
Requirements for Obtaining a Working Capital Loan
The exact loan requirements will vary depending on which type of working capital loan you seek. In general you can expect most lenders to require:
Time in business of at least one year – working capital loan approvals are based on track records so there typically needs to be at least one year of business history to be considered for a working capital loan
Personal Credit of at least 550 – some types of loans do not require personal guarantees but in general most lenders will evaluate the owners’ personal credit as a condition of loan approval
Annual revenues of at least $120,000 – if you are not depositing at least $10,000 a month in your primary business account it is unlikely you would be approved for a loan
A Word of Caution Regarding Long Term Working Capital Loans
It is technically possible to obtain SBA-backed loans for working capital needs. These loans are on the surface very attractive because their longer terms (7 to 10 years versus 6-12 months) make monthly payments much lower. This can be a slippery slope. Working capital loans are by definition used to help solve a short term cash flow challenge. If you set up a payment plan over several years, what happens when the next cash flow challenge arises (as they often do in business especially when you are growing)? If you obtained an SBA-backed loan, the blanket lien that ties up your business and personal assets will make it extremely difficult to obtain another business loan when you need it.
While there is no hard and fast rule, below is a general guideline of when it is appropriate to use various types of business loans:
Credit Cards – best for immediate needs that can be paid off within 30 days (supplies)
Working Capital Loans – best for 60-90 day needs that can be paid off within one year (inventory, onboarding a new hire)
Term Loans Ranging from 2 years to 20 years – best used for asset based purchases where the item being financed has a value that extends beyond the term of the loan (equipment acquisitions, real estate, vehicle purchases)