Working capital for small businesses powers daily operations and fuels growth. It’s the amount of liquid cash a small business has available for expenses like operational costs, payroll, and inventory. By definition, working capital is the difference between a business’s assets and debts (or accounts payable).
When a business has enough cash to cover its operating expenses and invest in future growth, it has positive working capital. When it doesn’t have enough, it has negative working capital.
If a business has negative working capital, it may want to seek out a working capital loan. There are numerous types of small business working capital loans available, including term loans, lines of credit, and invoice financing. Let’s walk through some options that may be a fit for your small business.
Key Points
• A working capital loan provides short-term financing for business expenses like monthly bills, payroll, inventory, and emergencies.
• These loans are not meant for long-term investments or big purchases.
• Types of small business working capital loans include SBA 7(a) loans, short-term loans, lines of credit, invoice factoring, inventory financing, merchant cash advances, and bank overdraft facilities.
• Businesses with unpredictable cash flows, such as restaurants, seasonal retailers, contractors, and startups, commonly use these loans.
• To qualify, determine the loan purpose and amount, assess your qualifications, choose the right loan type, select a lender, prepare documentation, and submit the application.
What Is a Working Capital Loan?
A working capital loan is a type of small business funding that can work well for a small business with negative working capital or fluctuating cash flow. This type of loan offers short-term financing to cover expenses like:
• Monthly bills
• Debt payments
• Payroll
• Inventory
• Operational expenses
• Emergency expenses
Unlike commercial real estate loans or large business loans, working capital loans aren’t intended for long-term investments or big purchases.
Since working capital loans are typically smaller loans, many types of lenders offer this type of business financing. Banks, credit unions, online lenders, peer-to-peer (P2P) lenders, and alternative lenders are all potential sources for working capital loans. Each has varying eligibility requirements and business loan terms, so it’s a good idea to do some research to determine which option suits your needs best.
What Can a Working Capital Loan Be Used For?
Many small businesses don’t have predictable cash flow or sufficient assets, resulting in negative working capital. Seasonality, sales cycles, holidays, or economic fluctuations can all contribute to negative working capital. It is common for startups, restaurants, manufacturers, or less-established small businesses to have negative working capital. Without reliable revenue, these businesses may turn to working capital loans.
Depending on your business needs, you can use working capital loans to:
• Manage cash flow: Working capital loans can help maintain smooth operations during periods of uneven cash flow, ensuring bills and expenses are paid on time.
• Manage seasonal business expenses: Businesses with seasonal fluctuations can use these loans to cover costs during off-peak periods.
• Cover emergency expenses: In the event of unexpected expenses, a working capital loan provides quick access to funds.
• Grow your business: These loans can also be used for short-term investments, such as marketing campaigns or purchasing additional inventory, to support business growth.
How to Calculate Working Capital
To calculate your business’s working capital, start by identifying your current assets and current liabilities.
Current assets are things that currently belong to your business and could easily be converted to cash within one year or one business cycle (whichever is shorter). These can include:
• Cash (checking and savings accounts)
• Accounts receivable
• Inventory
• Assets soon to be paid off or liquidated
• Stocks, bonds, and mutual funds
Current liabilities are expenses that must be paid within the next year or business cycle. These can include:
• Rent
• Utilities
• Supplies
• Principal and interest payments on any debt
• Accounts payable
• Accrued taxes
• Long-term debt that will be due in the short-term
After adding up your current assets and liabilities, calculate working capital using the following formula:
CURRENT ASSETS – CURRENT LIABILITIES = WORKING CAPITAL
For example, if your business has $200,000 in current assets (property, cash, inventory, etc.) and $75,000 in current liabilities (rent, debt payments, taxes, payroll), your positive working capital is $125,000.
$200,000 – $75,000 = $125,000
Conversely, if your business has $100,000 in current assets but $150,000 in current liabilities, you would have $50,000 in negative working capital.
$100,000 – $150,000 = -$50,000
Positive working capital is a sign of good business health. It’s usually an indicator that you’re in a good place to expand. Negative working capital can indicate financial troubles, which could ultimately lead to defaulting on debt payments or entering bankruptcy. For this reason, determining your working capital is an important step in planning for your business’s growth.
Types of Working Capital Loans
Working capital loans can help if your business needs extra cash. Several loan products offer short-term solutions. Keep in mind that not all will be suitable for every business, so be sure you understand each loan option before making a decision.
SBA 7(a) and 7(a) Express Loans
SBA loans are offered through approved Small Business Administration (SBA) lenders and provide flexibility for various working capital expenses. The SBA Express program offers a faster review time of around 36 hours, with a maximum loan amount of $500,000. The standard SBA 7(a) loan can provide up to $5 million but may take longer to process.
SBA-backed loans offer low interest rates and are suitable for short- and long-term expenses. Loans of $25,000 or less do not require collateral. However, eligibility requirements vary, and qualifying can be challenging. Good credit, proof of revenue, and a business plan are essential for application.
Short-Term Loans
Short-term business loans are used to secure working capital, providing a sum of money up front that is typically repaid with interest over 18 months or less. These loans are ideal for businesses needing quick cash that can repay the loan in a short time frame.
They are often easier to obtain for borrowers with poor credit or less-established businesses, as they pose less risk to lenders. However, short-term loans typically have higher interest rates and lower borrowing amounts than other term loan products.
Lines of Credit
A business line of credit is a small business working capital loan that can help manage cash flow and cover small expenses. Like a credit card, it provides a set credit limit to borrow from, with interest charged only on the money withdrawn. These lines of credit are often revolving but can also end when the balance is paid off.
This option is useful for businesses with seasonal fluctuations, sales cycles, or emergency expenses. It’s typically easier to qualify for business lines of credit because the funding amounts are smaller and the debt is short term. However, consider the additional fees and lower borrowing limits before opening a business line of credit.
Invoice Factoring
Invoice factoring is when a business sells its unpaid invoices to a factoring company at a discount in exchange for immediate cash to cover working capital expenses. The factoring company then owns the invoices and collects payments directly from the business’s customers.
This option can be ideal for businesses with irregular billing cycles, allowing them to cover operating expenses without waiting for customer payments. The factoring company provides a percentage of the invoice value up front, which can be used to reinvest in the business or pay expenses.
Costs can be high due to fees and high APRs, and the business loses control over collections, so choosing a reputable factoring company is essential.
Inventory Financing
Inventory financing is a short-term working capital loan that provides funds to purchase inventory, using the inventory itself as collateral.
This financing is helpful for retailers managing cash flow fluctuations due to seasonality or revolving inventory, allowing them to pay for products up front in anticipation of high sales periods. The amount of financing and interest rates can vary, and since inventory depreciates over time, the loan amount may not reflect the inventory’s original purchase price.
Merchant Cash Advances
A merchant cash advance offers businesses cash upfront in exchange for a percentage of future credit card sales, with automatic withdrawals made daily or weekly from the borrower’s bank account.
Merchant cash advances are helpful for businesses needing quick access to cash, especially those with bad credit or newly established operations without other loan options. They can be expensive due to higher costs associated with the increased risk to the lender, meaning borrowers pay more for the convenience of fast cash.
Bank Overdraft Facility
A bank overdraft facility provides a business with access to cash even if its account is empty or overdrawn. The bank continues processing payments for a set period so the business can meet its financial obligations.
This option is useful for small businesses with inconsistent cash flow or negative working capital. It acts as a backup plan until additional funds are available. Keep in mind that interest is charged on the loan, and there may be additional fees when an overdraft occurs.
Pros and Cons of Working Capital Loans
Working capital loans can be a valuable resource for small businesses needing immediate funds to cover operational expenses. Like any type of business loan, they have their own set of advantages and disadvantages.
The pros of working capital loans may include:
• May not require collateral (unsecured loans)
• Can help improve cash flow
• Let you maintain ownership of your business
• May involve a faster loan process than other products
• Come in numerous types of loan products
A few potential cons may include:
• Certain loans may require a higher credit rating
• Interest rates may be high on certain loan products
• May affect both your personal and business credit
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How to Get a Working Capital Loan
The process for getting a working capital loan for your small business will depend on the type of loan product and the lender. Generally, the following steps will help you find, apply for, and obtain a loan for your small business.
• Determine the loan purpose and amount: Consider how much money you need, how often you’ll be able to make payments, your budget for making payments, and whether you have any other sources of funding.
• Choose a loan type: Research the different types of loans available and choose the best fit for your business needs.
• Assess your qualifications: Check that your qualifications match the loan product you want to apply for. Some things to consider are personal/business credit ratings, collateral, and your working capital.
• Choose a lender: Compare small business lenders that align with your needs and qualifications (and their associated terms, conditions, and fees) before choosing the best fit.
• Submit your application: Prepare necessary documentation, such as financial records, business plans, and cash flow projections. Then, submit your application to the lender.
• Partner with your lender: After you’ve submitted your application, continue working with your lender to ensure that the process goes smoothly and you can receive funds promptly.
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Alternatives to Working Capital Loans
If you’re looking for additional financing for working capital or have long-term financing needs, the following types of loans may be helpful:
• Restaurant loans: Offered by several types of lenders, restaurant loans help with costs when you’re starting or expanding a restaurant business.
• Franchise financing: A franchise loan can help with the expenses of opening a franchise. There are franchise companies that specialize in offering loans specifically for franchise owners.
• Equipment financing: Equipment loans are useful for purchasing business equipment. The loan term is typically equal to the equipment’s expected lifespan, and the equipment acts as collateral for the loan.
• Personal loans: If you don’t qualify for working capital loans, you may want to consider a personal business loan. This type of loan can give you more flexibility than a business loan.
• Trade financing: Trade financing helps international businesses manage working capital by transferring payment or goods risks to third parties through options like bank guarantees and letters of credit.
• Customer advances: Consider charging customers in advance instead of at delivery to receive cash up front, which frees up working capital.
• Vendor credit: If you regularly purchase from the same vendors, ask if you can open a credit account. This allows you to pay your invoices in 30, 60, or 90 days.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What is a working capital loan?
A working capital loan is a type of business loan used to help pay for everyday operations and expenses. Types of working capital loans include short-term business loans, business lines of credit, merchant cash advances, and invoice financing.
How do you qualify for a working capital loan?
To qualify for a working capital loan, a lender assesses your credit, revenue, and business history. While there are working capital loans for startups and those with poor credit, the best loans and rates will be reserved for those with solid credit scores, a business history of at least one year, and positive revenues.
What is an example of a working capital loan?
An example of a working capital loan is a short-term business loan. These loans are typically 18 months or less and are given to the borrower in one lump sum. Payments are made monthly, and the interest rate is determined by the market and the business’s financial profile, including credit score and annual revenue.
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