What Is a Working Capital Loan? Pros, Cons and How To Qualify

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When your small business has temporary cash flow problems and you don’t want to touch your cash reserves, a working capital loan can help cover short-term expenses. Whether it’s for payroll, rent, inventory or general cash flow, this type of financing can help you keep operations running smoothly.

But what is a working capital loan exactly? Read on to find out — and see how it can support your business during short-term slowdowns.

What Is a Working Capital Loan?

A working capital loan is a short-term business loan that may be used to cover a company’s everyday operational expenses. These loans aren’t used for long-term investments but rather for short-term needs like paying employees, making rent or stocking up on inventory.

How a Working Capital Loan Works

With a working capital loan, a business will likely reach out to a financial institution to borrow money. The purpose of these funds is to cover short-term needs, and repayment happens over a set period. 

There are different ways to structure the borrowing. Businesses can get a term loan, merchant cash advance or line of credit. Repayment terms can be for a few months or a few years depending on the lender. 

5 Types of Working Capital Loans

1. Short-Term Loans

Short-term loans run for a fixed period, typically a year, with a set interest rate. It is usually paid as a lump sum and can be repaid in fixed installments.

While short-term loans usually require some type of collateral, banks may waive the requirement if you’re already a customer with a good credit rating. This loan is ideal for emergency purposes. 

2. Business Lines of Credit

This type of loan is a credit line that requires interest payments on the overdrawn amount. The interest rate runs about 1% to 2% over the prime rate.

Businesses use this credit line to withdraw funds as needed. For repayment, the business pays interest only on the amount used. 

3. Invoice Financing

If you have steady sales and a good business credit score, you may qualify for an invoice financing or accounts receivable loan. With this loan, you can borrow against unpaid invoices to access funds quickly.

This loan is best for a business with slow-paying customers. 

4. Merchant Cash Advances

Businesses that need quick, short-term capital and have strong daily sales may opt for a merchant cash advance. Businesses will receive a lump sum amount.

Repayment is made through daily debit and credit card sales. Repayment is adjusted based on sales volume. 

Although funding is quick, a merchant cash advance has high interest rates and fees. 

5. SBA Working Capital Loans

SBA working capital loans like SBA 7(a) and CAPLines are government-backed loans specially designed for working capital needs. These loans have lower interest rates than traditional banks.

Repayment terms may last up to 10 years in certain circumstances. 

Working Capital Loan vs. Business Loan: Key Differences

What are the differences between a working capital loan and a business loan? Here’s a look: 

Working Capital Loans: Pros and Cons

What are the advantages and disadvantages of working capital loans? Here is a comparison between the pros and cons: 

How To Qualify for a Working Capital Loan

Just like a personal loan, a working capital loan will require a bank or other lender to evaluate your eligibility.

You need the following qualifications: 

• Strong business revenue:
  • You must show that you have stable cash flow and a history of consistent revenue. 
• Good credit score:
  • A traditional bank will require a credit score of 680 or more. This helps to secure approval and get a lower interest rate.
• Right documentation:
  • Some lenders may require financial statements, bank records or invoices.

When Should You Get a Working Capital Loan?

How do you know when the right time is to get a working capital loan? You’ll have to reflect on your cash needs.

A working capital loan is best when your cash flow is low and you have to cover seasonal expenses or handle unexpected costs. 

Good To Know

A working capital loan can be a smart solution for covering short-term growth opportunities without tapping into your savings. It’s also helpful when accounts receivable are delayed, giving your business the flexibility to stay on track while waiting on customer payments.

Where To Get a Working Capital Loan

Can you get a working capital loan at any lending institution? The short answer is yes. Each financial institution has its advantages.

Here are the places you can get a working capital loan: 

• Banks: 
  • A bank offers low interest rates and a repayment schedule.
  • Going to the bank for a working capital loan is best for established businesses with good credit. 
• Credit unions:
  • If you’re a member of a credit union, you’re likely to receive lower interest rates than at other financial institutions. 
• Online lenders:
  • For a working capital loan, you will receive quick approval and fast funding.
  • There are typically fewer credit requirements, but you will pay higher interest rates. 
• SBA loans:
  • SBA 7(a) and CAPLines are government-backed, but expect to complete a detailed application process.
  • The interest rates are lower and terms tend to be longer. 

Final Thoughts: 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 to fulfill that requires an investment in raw materials. A working capital loan lets you buy those materials, and soon after, you will have the funds to pay it off when the customers pay for the finished goods.

If you’re looking to manage short-term expenses and cash flow gaps, a working capital loan may be a good fit for you. Generally, businesses researching working capital loans should look at interest rates, repayment terms and lender options. These factors will impact borrowing. 

You can use a working capital loan to your advantage as it can help stabilize finances and support business growth.

Barb Nefer contributed to the reporting for this article.

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