When your small business has temporary cash flow problems and you don’t want to touch your cash reserves, working capital loans can get you through rough times.
A simple way to determine your working capital is to subtract your current liabilities from your current assets. You’re in good shape if there’s at least a 2:1 ratio. If the ratio is below 1:1 for your assets and liabilities, you have negative working capital and might need a working capital loan to cover immediate needs to keep your small business running smoothly.
Types of Working Capital Loans
Like most loans, working capital loans come in different forms. It’s important to understand how different types of working capital loans vary so you can choose the right loan for your business. Here are five common types of working capital loans:
Credit Line/Overdraft Protection
This type of loan is a credit line that requires interest payments on the overdrawn amount. Its interest rate runs about 1 to 2 percent over the prime rate.
Short-term loans run for a fixed period, typically a year, with a set interest rate. While short-term loans usually require some type of collateral, banks might waive the requirement if you’re already a customer with a good credit rating.
Equity Funding From Investors
Investors might loan you money, particularly if they’re family or friends, making it a good option for start-ups without an established business credit score.
Accounts Receivable Loans
If you have steady sales and a good business credit score, you might qualify for an accounts receivable loan. A similar loan type, known as advances or factoring, is based on your future credit card receipts if your business accepts credit card payments.
Your suppliers might give you a trade creditor working capital loan in exchange for placing a bulk order with them. They’ll also want to see a strong credit history.
Pros and Cons of a Working Capital Loan
Amongst the biggest pros is how quickly you can get working capital business loan funds in your hands. You might be approved in a day and have the money within 72 hours, depending on the lender. You don’t need a perfect business credit score to qualify, nor do you always need collateral.
While a working capital loan helps you fill in a short-term financial gap, you must pay it back more quickly than other types of loans. Working capital loans cost more because they carry a higher APR than a regular loan. And because they’re relatively easy to obtain, you can get yourself and your business into financial trouble by borrowing more than you need or taking out these loans too frequently.
Typical Terms for a Working Capital Loan
Many financial institutions offer small business working capital loans. For example, American Express National Bank offers loans to its Business Card customers with 30-, 60- or 90-day repayment periods, no collateral required and rates between 0.50% APR and 1.50% APR. The loan amount runs from $1,000 to $750,000 and must be used to finance vendor payments.
The Small Business Administration also offers loan services to for-profit businesses in the United States that have invested equity and cannot get financing elsewhere. SBA loans come from partner lenders found through the SBA matching program. The SBA 7(a) loan program provides working capital loans with interest rates ranging from 6.25% APR to 8.50% APR, for example.
How Working Capital Loans Compare to Other Options
Like a standard term loan, a working capital loan can have a fixed or variable APR and might require collateral. The main difference is the length of repayment, with term loans usually running from one to five years as compared to the shorter working capital loan period.
Alternative to Working Capital Loans
A merchant cash advance is an alternative to a working capital loan. A small business without a strong business credit score can qualify if it has consistent daily sales. The lender gets daily payments based on debit and credit card transactions. That amount varies, depending on sales, and the daily payments continue until the loan is satisfied. A merchant cash advance is not technically a loan and is therefore not bound by usury laws, so beware of predatory terms.
Make the Choice: Business Loan vs. Business Credit Card — Which Should You Choose?
Is a Working Capital Loan Right for You?
If you need to keep your business running while your money is tied up elsewhere, a working capital loan can help tide you over. For example, you might get a big order that requires an investment in raw materials to fulfill. A working capital loan lets you buy those materials, and soon after, you get the funds to pay it off when the customers pay for the finished goods.
Working capital loans also help seasonal businesses that make good overall annual revenue. For example, you might need working capital to buy inventory in fall to prepare for the holiday season rush, or the loan might help you purchase supplies in winter to have your landscaping business ready in spring. These loans might be right for you if your business is sound but needs cash temporarily.