How to Use a Working Capital Loan for Your Business

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Updated on Tuesday, May 29, 2018

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It takes money to make money, but sometimes it’s difficult to obtain the capital you need to run a profitable business.

Despite business owners’ best efforts to plan monthly expenses around anticipated revenue, unexpected costs can throw off the entire plan. For those struggling to fund their daily operations, working capital loans could provide a quick solution.

What is working capital?

Working capital is the money available to fund a business’ day-to-day operations. To determine working capital, business owners subtract their current liabilities from their current assets. The formula defines whether a company has enough cash on hand to pay its immediate expenses.

A business owner’s personal savings or a loan could supply working capital, which fills the gap between expenses and the amount of income the business is generating, Joel Youngs, regional director of the Eastern Iowa Small Business Development Center, told MagnifyMoney.

“There’s an ebb and flow in the expenses a business owner has to pay in a given month versus the money that’s coming in,” Youngs said. “When life throws a curve at you, you access that money to pay the bills.”

Business owners increasingly need help making ends meet on a short-term basis. Working capital was the main reason 66 percent of U.S. business owners sought financing in the second quarter of 2017, up from 54 percent during the same period in 2016.

“If you’re generating enough cash internally where you don’t have to borrow money, that’s great. That’s the ideal situation,” Leonard Briskman, team leader of advisory services for SCORE’s Washington, D.C., chapter, told MagnifyMoney. “But I would think most businesses would have to borrow money.”

Working capital can be both positive and negative. Positive working capital means a business has enough funds to pay short-term bills and finance their growth. Negative working capital shows a business isn’t using its assets effectively and may not be able to cover unexpected liabilities. This could lead to additional borrowing, late payments and a lower credit rating.

Understanding working capital loans

A working capital loan could fall under the broad umbrella of term loans — lump-sum loans paid back over a fixed amount of time (the term), generally with fixed interest rates and fixed payments. A working capital loan could also come in the form of a line of credit or a merchant cash advance, which both allow you to access capital quickly and pay the lender back at a later time.

Pros:

  • A working capital loan could be used to cover any business expense for an owner in any industry. You could receive the money in as little as three weeks if your financial details are in order, Youngs said.

Cons:

  • While working capital loans could quickly cover unexpected expenses, the loans could also get too big, too fast, Youngs said. If you took out a loan to cover six months’ of additional work and that work turned out to last seven or eight months, you would have to borrow more money on a short-term basis. That means you would go into more debt, which could lead to higher interest rates and, ultimately, profit loss.

When to consider a working capital loan

You should apply for a working capital loan long before you plan to use it, Youngs said. You should get an early start on the application with a bank or other loan provider, as it could be a few weeks to several months before you have access to the money.

The following situations indicate you may soon need a working capital loan:

An increase in hiring. If you’ve hired more employees to expand the business, a working capital loan could cover those employees’ salaries until the business becomes profitable enough to sustain the new paychecks.

An upcoming slow season. Some businesses perform better during certain months of the year. A working capital loan could cover expenses to keep the doors open until the busy season rolls around again.

An increase in orders. Oftentimes customers will place orders for products or services before paying, creating a lag between expenses and income. For example, a carpenter could be contracted to build a room extension in a house but would not receive a check until the work is completed in two or three months. A working capital loan would help the carpenter bridge the gap between starting the work and receiving payment from the customer.

Is working capital financing right for you?

Business owners who experience frequent ups and downs in revenue would benefit most from working capital loans, Youngs said. Any business owner could use this type of financing to hold them over until payday, and it isn’t limited to a specific industry or type of business.

“The more time your business has between getting the work done and getting it paid for, the more you should consider a working capital loan,” he said.

If you have the option to tap into personal money to support working capital, then you could avoid getting into debt with a loan, Youngs said.

Business owners should avoid a working capital loan if they’re not generating enough money to stick to a repayment schedule, Briskman said. Typically, a lender would be able to tell if you’re not equipped to handle debt and would not offer financing.

“After a while, if the company starts falling back on the payments, it creates all types of problems,” Briskman said.

Shopping for working capital financing

Business owners can apply for working capital financing from traditional banks and non-bank commercial lenders, many of which operate online. These institutions tend to lend to people who have an established business and a good credit rating, Briskman said. There are several different forms of working capital financing for owners looking for an infusion:

Short-term loans

Short-term business loans allow you to quickly borrow a small amount of money. The funding could be available in as little as 24 hours. However, you must pay off the debt within three to 36 months, and some loans carry a high APR.

Short-term loans could be a good solution for a temporary cash bind, like covering seasonal costs or an expensive project, Briskman said. He recommends keeping these loans within a 12-month repayment period to maintain low debt. Shorter loans do come with more frequent bills, and you could be required to make a daily payment. Short-term loans tend to be capped at $500,000, so you may have to turn to a different form of financing if you need more than that.

Business lines of credit

Rather than borrowing a large amount all at once, you can access money as you need it with a business line of credit. You only pay interest on the amount you borrowed, but interest rates are generally higher for lines of credit than for short-terms loans.

This type of financing would be best for covering an immediate, unexpected expense, Briskman said, and you only have to borrow the exact amount you need. Like a short-term loan, a line of credit should be paid back within 12 months because of high interest rates, he said. Once you’ve paid off the amount you withdrew, the full loan would be available again for future expenses.

Merchant cash advances

A merchant cash advance provides capital in exchange for a percentage of your future debit or credit card payments. This type of lending is available from non-bank lenders, many of which are online, and the repayment schedule is based on your business’ revenue trend. The more card transactions you process, the faster you pay off the debt. This option could be expensive, as you could pay back between 20 percent and 40 percent more than your original advance.

Merchant cash advances are commonly used to finance new equipment purchases, building expansions, remodels and seasonal merchandise. Businesses are required to make a minimum amount in or certain percentage of card transactions each month to secure a merchant cash advance. Repayments are integrated into your business’ credit card processing system, so the lender gets a cut of each transaction before you see any of the money. Some lenders may require you to move to an approved processing system before issuing the advance.

Unlike loans, merchant cash advances are practically unregulated and most are issued without disclosing APR or expected monthly payments. Lenders often target business owners with poor credit who are unlikely to be approved for a loan, but high interest rates and large, frequent repayments make merchant cash advances a risky choice.

SBA loans

An SBA loan is provided through a bank that is backed by the Small Business Administration. These loans typically have competitive terms and require low down payments. But SBA loans have strict eligibility requirements and they don’t allow you to borrow from another lender once you’ve been approved for an SBA loan. That means if the SBA doesn’t loan you as much as you’d hoped, you cannot go to another lender for additional funds.

Banks could charge between 7 percent and 9 percent in interest on SBA loans, Briskman said. SBA loans require a large amount of financial documentation and detailed business projections, and businesses have a better chance of securing this type of financing the longer they’ve been in existence, he said.

Applying for a working capital loan

When reviewing applications for any type of business loan, Youngs said banks look at five factors — the business’ cash flow, creditworthiness, collateral, capacity to repay the loan and the character of the owner. Lenders prefer to work with people who are trustworthy and have enough cash flow to cover the debt.

Applying for a working capital loan could take weeks or months, depending if the business owner has their financial documents ready to go. Small business loan providers need profit and loss statements, current cash flow for established businesses or projected cash flow for new businesses, and a balance sheet.

The application requirements vary by type of financing you’re looking for, as well.

Short-term loans

A traditional bank or a non-bank commercial lender would look at your credit score and cash flow projections before approving you for a short-term loan. Lenders usually prefer borrowers with an average credit score and consistent monthly revenue. They would also expect to review your business plan, balance sheet, tax returns, active accounts and proof of licenses related to your industry. If your documents are in order, you could be approved in as little as one day.

Business lines of credit

Lenders would check your personal credit score, generally preferring a score of 600 or higher. They would also take into consideration how long you’ve been in business, requiring anywhere from six months to two years of operation. Lenders’ revenue requirements would depend on how much money you’re looking to borrow through a business line of credit, but they would also look into your accounts receivables to determine what physical assets your business possesses. Like a short-term loan, you could receive a business line of credit at either a traditional bank or non-bank lender.

Merchant cash advances

You could also find a merchant cash advance through a non-bank lender. You would be required to provide several months’ worth of credit card payment processing data, as well as bank statements, your Social Security number and business tax ID. The lender may require you to switch to a new credit card processor before approving the advance. Once you’re approved, which could be in as little as 24 hours, the payments could start as soon as the next day.

SBA loans

The SBA backs hundreds of banks across the country. Check out this list of the most-active lenders of 7(a) loans, the SBA’s primary loan for small businesses, to find a bank in your area. To apply for a 7(a) loan, you would need to follow a multi-item checklist, which includes submitting business financial statements, the business’ existing debt schedule and documents supporting collateral, such as real estate appraisals or lease agreements. The application process for an SBA loan could take between two and five months.

Businesses become less risky to lenders the longer they’ve been around, so older businesses would be able to apply for larger loans to cover working capital expenses.

But whatever the reason behind your need for working capital or the amount you’re looking for, the best strategy to quickly obtain capital is maintaining a reputation as a trustworthy business owner, according to Youngs. “Not all lenders may want to approve your loan,” he said. “It’s important to get a good banking relationship with your lender so when you come up with some quirky idea they don’t think you’re nuts.”

How to improve your chances of getting a working capital loan

It could take months or years for new businesses to generate positive cash flow, Briskman said. These startups are the most likely to need working capital loans, but they have the lowest likelihood of being approved for traditional financing.

The majority of people starting a business have to rely on their own funds, money from friends and family or alternative solutions like crowdfunding to get the business going, Briskman said. They’ll have a better chance of being approved for working capital financing once they can show the business has made progress.

“They don’t necessarily have to be profitable, but they have to be close to profitable and showing that every month is better than the previous month,” Briskman said.

Financial institutions may also look for a business plan from new entrepreneurs showing how they plan to grow the business and make money in the future, as well as how much they expect operations to cost.

“They want to see projections,” Briskman said. “A business plan really gets you to focus on where you see your business going.”

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