Working capital loans are a great financial product to meet operation business expenses of running a small business such as payroll, rent, and cash flow gaps during seasonal lulls. They are used for short-term financing needs and not for long-term financing or assets purchase. You can use a working capital loan for any purpose without submitting the loan’s purpose to the lender.
Experiencing cash flow issues can be extremely nerve-wracking and disheartening for any small business owner. According to Nav’s American Dream Gap Report, almost 20% of small businesses closed down due to cash flow issues. Working capital loans provide the needed influx of capital your business needs to pay for expenses during an emergency or downturn.
Calculation of Working Capital
In a business balance sheet, working capital includes all current assets such as cash on hand, inventory, accounts receivable, and prepaid insurances. These assets can be quickly turned into cash, if necessary, to pay for current business expenses.
A net working capital is a financial metric used to analyze the strength of a small business. Here’s the formula you to calculate your small business’ working capital:
Working Capital = Current Assets – Current Liabilities
According to QuickBooks, a good working capital ratio is 2:1; twice as much in current assets as in current liabilities. With a high ratio number of current assets, you can pay off current liabilities, typically at a loss.
Here’s the formula to calculate your business’ working capital ratio:
Working Capital Ratio = Current Assets ÷ Current Liabilities
Types of Working Capital Loans
- Bank Overdraft Facility or Credit Line
- Short-Term Loans
- Equity Funding via Personal Resources or Investors
- Factoring or Accounts Receivable financing
- Trade Creditor
- Equipment Financing or Leasing
- Merchant Cash Advances
The Basics of Working Capital Loans
- The Terms
You can secure a working capital loan for any duration: from a few weeks or months to several years. Typically, these loans are for short-term financing needs to manage operation business expenses. For unexpected or emergency expenses, you can also use (now always) a revolving line of credit.
- Loan Amounts
The loan amount of a working capital loan can range from $5,000 to $1 million. The higher the loan amounts, the longer the duration will be, since the regular repayment amount is likely maintainable.
Working capital loans have fixed repayments — typically, they’re based on lenders that offer weekly or bi-weekly repayments. Since they’re classified as demand loans, the lender can ask for repayment at any time. This is why the loan repayment is automatically deducted from your bank account, eliminating and preventing missed payments from borrowers.
- Collateral Requirements
Most lenders — such as Merchant Advisors— don’t require collateral for working capital loans. The approval process is easy, without requiring borrowers to pledge their valuable assets or experience a laborious collateral valuation process.
- Approval Criteria
There is no standardized approval criteria for working capital loans. Some lenders have strict policies like conventional bank loans, while some lenders offer flexibility and, reasonable requirements. At Merchant Advisors, we approve about 90% of all working capital loan applications. Our valuation process doesn’t take into account your credit profile only or specific time in business. The application process is quick and simple, with quick approval decisions within 24hrs, and funding in a few business days.
Pros and Cons of Working Capital Loans
Pros of Working Capital Loans
- You’re always prepared to manage unexpected financial difficulties
- You retain the ownership of your business
- There’s no collateral requirement
- Shorter terms for short-term problems
- You can use the funds the way you see fit
- They approve quickly within 24hrs
Cons of Working Capital Loans
- You need to repay a loan even when you don’t have the resource
- Some working capital loans require collateral
- There carry higher interest rates due to unsecured nature
- Loan undertaking means potential impacts on your credit profile
- They offer shorter terms
When You Need a Working Capital Loan?
While starting a new business, you need capital to pay for operational costs since there’s little money available at the start. At startup time, you should consider applying for a working capital line of credit, which allows you to borrow money from your approved credit line as and when required to fill cash flow gaps or to meet short-term financing needs.
When your business is experiencing change, growth, and expansion, and you need a quick influx of cash to steer through the change, support growth and finance the expansion. In such cases, you should consider a working capital loan to help your small business grow.
How Do You Know A Working Capital Loan Is the Right Choice?
Working capital loans not only give you the ability to start your business but also to keep it running efficiently. Working capital loans are more flexible than other types of loans, allowing you to use the funds for any type of expenses, unlike specific purpose loans, such as home loans or equipment loans. In addition, timely payments of a working capital loan can help build your business credit score as well as maintaining full equity in your business.
In the end, to determine whether a working capital loan is the right choice for your small business is depends on how it will be used and the cost involved. Before borrowing money, make sure to do your research thoroughly regarding your loan options.