Working Capital Loan

What is a Working Capital Loan?

Updated: March 10th, 2021

What is a working capital loan

Small business financing has been a lifeline for many entrepreneurs during the pandemic, but small business loans can be a great way to unlock growth, even when times aren’t so tough. Business owners can use financing as a tool to build their business through hiring, marketing, purchasing inventory, and more. With so many different types of small business loans available, however, it can be difficult to decide on a financing solution that suits your needs. 

One flexible type of financing, which is often a great option for small business owners looking to increase cash flow without taking on a long term debt obligation, is a working capital loan. Working capital loans are typically best for short-term financing needs such as buying inventory, paying invoices, or covering payroll. Let’s explore the role of working capital in a small business and how a working capital loan can work best for you.

Working capital explained

Working capital is the amount of cash a business has on hand to cover day-to-day business expenses like payroll, electricity bills, supplies, and rent, to name just a few. Your working capital can be calculated by subtracting your liabilities from your assets. If the resulting number is negative, or too low, you might decide that a working capital loan fits the bill.

What are working capital loans good for?

Working capital loans are designed to help cover short-term financing needs. Whether this is to meet payroll, buy supplies, replenish inventory, hire more talent — you get the idea. There are few limitations. Whatever the challenge, chances are a working capital loan can do the trick.

There are a handful of reasons to consider a working capital loan. They are often unsecured, which means you won’t need to put up any collateral to secure the loan. It’s worth noting, however, that unsecured loans are typically reserved for businesses that have a strong credit profile with little risk of default. Other benefits include the flexibility to use the money however you see fit, maintaining ownership of your company by not having to sell any equity, and a straightforward and fast application process.

There is more than just one type of working capital loan, however, and it’s important to find the right business loan for your specific needs. Let’s explore some of the most popular working capital loans. 

Term loan 

If you’ve ever taken out a home mortgage or auto loan, then you are probably familiar with how a term loan works. You receive a lump-sum upfront, which is repaid over a specified term with interest. The payment terms can range from daily to once monthly. 

Considering that working capital loans are meant to meet short term needs, the repayment period is often short-term, and can be anywhere between 6 to 18 months. In order to qualify for a short term loan, you typically need a couple of years of operating history under your belt. Lenders often suggest these loans for businesses with predictable cash flow, because  you will be required to make regular payments. 

Depending on the lender, term loans can be secured or unsecured. If a business owner’s credit is in tip-top shape and they show little risk of defaulting, they could qualify for an unsecured loan. This type of loan would require no collateral (which could be the business itself or inventory, for instance). The interest rate on an unsecured loan could be higher than a secured loan since the lender is inheriting more risk in case of a default. If the loan is secured, the lender will specify the type of collateral that is required. 

Line of credit 

A line of credit could be the right working capital solution if you’d like to have cash on hand to cover expenses as they arise. A line of credit works similarly to a credit card in that you gain access to a pre-approved amount of credit that you are able to draw from as needed. The amount you qualify for is often based on factors like credit history and cash flow. 

With a line of credit, interest is only charged on the amount that is used and repayment begins when you draw on the capital, though there could be a monthly maintenance fee. If the line of credit is revolving, you can borrow up to the maximum amount, repay the loan and then borrow again. This is because the term hasn’t reached maturity. If the line of credit is non-revolving, you can’t borrow again after the balance has been repaid. 

Merchant cash advance

merchant cash advance (MCA) is another type of working capital loan which allows you to trade tomorrow’s earnings for cash today. With an MCA, you receive a lump sum of cash upfront, and then you pay back the advance with a percentage of your daily sales. You’re essentially selling your future sales at a discount.

If you are approved for an MCA, the lender will deliver a lump-sum amount into the business owner’s bank account, which is automatically paid back with a percentage of daily sales. 

Daily payment amounts will ebb and flow with sales — when sales are high, your payments are higher, and when sales are down, the payment will be lower. Approvals are based on sales more than a credit score, which can be helpful to a business that is just starting out and doesn’t have an established credit history yet.

There are two terms you should be familiar with for an MCA: factor rate and holdback rate. The factor rate, which is expressed in decimal form, determines the cost of the loan and it could range anywhere between 1.1 and 1.5. If your advance is for $25,000 and you have a factor rate of 1.15, then you will owe $28,750.  The holdback rate is the percentage of sales that will automatically be held back from daily sales for repayment. The constant variance in MCA costs makes it difficult to budget week-to-week and month-to-month. Normally, when your sales go up, you’ll have additional revenue to invest in other parts of the business. However, with an MCA, more sales lead to more correlated expenses—which can be a challenge to plan for in your budget.

There you have it, the best small business loans for working capital plus an MCA, one of which could make all the difference when a business is experiencing a cash crunch.

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