What Is a Working Capital Loan?

Managing cash flow can be challenging. As a small business owner, there may be times that you don’t have enough cash on hand to cover short-term expenses like payroll or monthly expenses like rent. 

‍

The question becomes: what to do when your cash flow declines. Should you apply for a new credit card? Or take out a small business loan? 

If your main goal is to cover immediate expenses, consider taking out a working capital loan. Working capital loans are intended to help you with your operational expenses. What’s more, they’re easier to apply for than traditional loans. 

Read on to learn more about working capital, working capital loans, and more.

What Is Working Capital?

Working capital is the difference between a business’s current assets and their current liabilities and can indicate whether a business can cover its operating costs. 

It is calculated by:

Working Capital = Current Assets – Current Liabilities

Here, current assets include the assets you expect to use or convert into cash within one year. Common examples include cash, accounts receivable, inventory, supplies, and cash equivalents. 

Meanwhile, current liabilities refer to the liabilities that you expect to pay within a year. That includes payroll expenses, accounts payable, and the current portion of long-term debts. 

You need to have working capital to pay for your expenses and stay in business.

How To Increase Your Working Capital

There are several ways a business can raise its working capital, such as:

• Selling long-term assets for cash
• Applying for a small business grant
• Finding cheaper suppliers and vendors
• Taking advantage of tax incentives
• Using a business credit card
• Borrowing cash

However, if you run a small business, you may not have long-term assets to sell or enough leverage to negotiate vendor rates. A business credit card appears to be a decent choice, but it comes with higher initial and annual costs. 

Similarly, while small business grants are an excellent way to increase your working capital, the competition is too fierce for them to be reliable. 

So, borrowing cash is a strong option.

How do you borrow?

Technically, you can take out a personal loan and use it for your business. Personal loans have lower interest rates and a faster approval process. If you have built up your personal credit, you can get a personal loan within a couple of days. 

On the other hand, banks look at both your business and individual credit scores when you apply for a business loan.

Still, you need to think twice about taking out a personal loan for business for these reasons:

‍

• Risky for assets and personal credit: If you take a secured loan and put up your personal assets as collateral, you will lose the assets if you don’t pay on time.
• Difficulty with separating finances: When you take a personal loan to pay off your business expenses, it can be difficult to separate the two.‍
• Complicated tax deduction: Unlike other personal loans, the interest paid on personal loans used to finance business operations is tax-deductible. However, you have to ensure the borrowed money is spent on the business tasks to get those tax deductions, and that you got the loan from an established lender.

Personal loans may seem like a quick option, but mixing your personal finances with your business puts your assets at risk and complicates your tax filing process.

So, what’s the better option?

If raising working capital for your business is the primary goal, a working capital loan is an excellent choice. 

Like a personal loan, it also features a faster approval process and can get you money within days. However, it keeps your business and personal finances separate and usually doesn’t require collateral.

What Is a Working Capital Loan?

A working capital loan is a flexible loan option for businesses that require cash to cover immediate expenses. It is often used to fund expenses related to daily operations like payroll, rent, and operational costs. 

You can choose from varying interest rates and repayment terms. In particular, working capital loans are useful for cyclical or seasonal businesses like restaurants and construction that require cash to cover operating costs during the off-season. 

Can you take a working capital loan when your business is doing well?

Absolutely! Working capital loans aren’t limited to overdue bills – you can also take one out when your business is doing well. For example, your business is expanding so fast that you need to move to a bigger location and hire more people. The loan can cover the cost of moving out and hiring new workers.

In other words, working capital loans are short-term loans that help you manage gaps in your cash flow and keep your business running. 

How You Can Use a Working Capital Loan

Working capital loans are used to cover the short-term operating expenses of businesses. Here are some examples of how you can use these funds:

Payroll

Employees are the backbone of your business. You need to pay them on time to retain them long-term. If you run out of cash to pay your employees, you should consider a working capital loan. 

Suppose payroll is due in a week and the accounts receivable in a month. The cash from a working capital loan can help you pay for both of these things. 

Hiring

You can use a working capital loan for hiring. If you find yourself short-staffed but lack the finances to hire new employees, a working capital loan may be just what your business needs to get out of that predicament.

Investing in Equipment and Inventory

You can use working capital loans to invest in equipment or purchase inventory. 

For example, if you would like to upgrade a piece of equipment you need to run your company, you can use a working capital loan if you don’t have the cash to pay for it. 

Unexpected Expenses

As much as small business owners plan and strategize, unexpected expenses come up. Working capital loans can cover anything from sudden equipment failure to fire or flood damage.

Benefits of Working Capital Loans

Several financing options are available when raising money for short-term business expenses. 

Why opt for a working capital loan? 

Here’s why a working capital loan is the best type of small business loan for covering immediate expenses.

Easy Application Process

Online lenders are a major source of working capital loans. They often have fewer requirements than banking institutions, resulting in quicker processing and disbursal of funds. 

For example, online lenders like BlueVine and OnDeck approve applications and release funds in one business day, whereas traditional banks can take weeks to months.  

No Collateral with Good Credit Score

There are two types of working capital loans: secured loans and unsecured loans. Secured loans require you to put up assets as collateral to ensure you pay off the debt.

‍

In contrast, an unsecured loan doesn’t require collateral. Instead, banks look at your credit history and usually require that you sign a personal guarantee stating that you’ll pay off the loan.

While most bank loans are secured loans, you can find lenders that provide unsecured working capital loans if you have good credit.

These also help new businesses that lack the assets for collateral. Still, you’ll need a good credit history to get an unsecured loan.

‍Flexible

Working capital loan providers also offer more flexibility in their requirements when looking at:

• How long you’ve been in business
• The strength of your credit score
• Whether you have consistent cash flow
• The status of your business finances
• How many unpaid invoices you have

For example, while an SBA loan may require one year in business, an online working capital loan provider can still approve your application if you’ve been in business for only a few months. 

The same is the case with their interest rates and repayment plans. You can choose a loan or even lines of credit that better fit your company’s cash flow. 

Retain Ownership of Your Company

One of the primary benefits of taking out a working capital loan is that you don’t have to give up any equity. Unlike raising venture capital from an investor, taking out a working capital loan allows you to retain full ownership of your company.

Drawbacks of Working Capital Loans

While the benefits mentioned above are attractive, consider these cons first before you fully commit.

High Interest Rates

Working capital loans are short-term loans, which mean they come with higher interest rates than long-term loans. Loans from unsecured lenders also come with higher interest rates.

Collateral Required

As we discussed earlier, there are two types of working capital loans: secured loans and unsecured loans. Secured loans require you to put up assets as collateral to ensure you pay off the debt.

Quicker Repayment Period

Working capital loans are loans intended to cover a brief hiatus in your cash flow, thus have a shorter payback period than other loans. If you plan to take one out, be sure to plan your cash flow carefully.

Types of Working Capital Loans

 When looking for a working capital loan, you have several options. 

Secured loans tend to have more requirements but offer lower interest rates and accept poor credit scores. On the other hand, unsecured loans require a good credit rating and come with a higher interest rate.

Common types of working capital loans include:

Bank Overdraft or Credit Line

A bank overdraft or credit line is the most flexible working capital loan. The lender approves a predetermined loan amount that they can lend a borrower, and the borrower must not exceed that amount. 

As a borrower, you are only charged interest on the amount that you borrow.

Short-Term Loans

A short-term loan comes with a fixed interest rate and repayment period — usually 12 months. Secured short-term loans offered by banks are more common, but you can get a short-term unsecured loan with a good credit history.

The difference between a bank overdraft and a short-term loan is that short-term loans have a fixed amount with set terms, while overdrafts allow you to borrow a variable amount, as long as it is within the agreed bank-approved limit. Because it’s so easy to get an overdraft, interest rates tend to be higher.

Overall, overdrafts are better for unexpected expenses, while short-term loans are recommended for higher-value expenses such as covering the cost of equipment for expansion.

Merchant Cash Advances

A merchant cash advance is a type of alternative financing that gives you cash upfront in exchange for a percentage of your future sales. 

Merchant cash advances have historically been used for businesses whose revenue comes primarily from credit and debit card sales like restaurants. 

Invoice Factoring

Invoice factoring, also known as invoice financing or accounts receivable loans, are secure loans wherein businesses sell their unpaid invoices at a discount to another company to raise business funding. 

The factoring company pays you immediately and collects payment from your customers later on.

Trade Credit

Trade credit is a working capital loan extended by a potential supplier. In other words, your supplier agrees to give you the raw materials on credit.

You get to source the required raw material without immediately paying for it.

Where To Get Working Capital Loans

While banks offer working capital loans, working with an online provider offers several benefits.

Banks have an intense application process and a tendency to reject loans. In contrast, online lenders have quick approval processes that allow you to get funding in days or even hours.

Some examples of working capital loan lenders include:

• Small Business Administration (SBA): SBA CAPLines, a group of 7(a) SBA loans, assists small businesses with seasonal or cyclic needs to cover their working capital gap. It features four lines that suit various businesses.
  
  For example, Builders CAPLine finances the labor and material costs of small contractors.
  
  
• PayPal: PayPal offers working capital loans to businesses with strong PayPal sales.
  
  
• BlueVine: BlueVine is an SBA-approved financial technology that provides business financing to small business owners for their working capital needs.
  

How To Apply for a Working Capital Loan

Due to the flexibility of working capital loans, the application requirements and procedures vary as well. A general step-by-step process for getting a working capital loan is:

1. Choose the type of working capital loan you are looking for.
2. Check requirements, including your credit score, and make sure you meet the criteria.
3. Prepare your detailed personal and business bank statements.
4. Apply for the loan.

If you are wondering about required documentation, online lenders usually ask for:

• Government-issued IDs
• 1-2 years of personal tax returns
• Credit score
• 2-3 months of bank statements

If you have a good credit score, you can get access to funds within a couple of days.

On the other hand, SBA CAPLines have extensive requirements. You need to submit SBA Form 1919 (borrower information form), SBA Form 912 (statement of personal history), SBA Form 413 (personal financial statement), and more. 

Even then, it can take you from two to six months to get access to the required funds.