A Complete Guide to Working Capital Loans

Barbershops, schools and coffee shops are very different types of small businesses but they all have one thing in common— all require a steady flow of working capital. Without sufficient cash flow on hand, it may be difficult to handle short-term financial needs, such as covering payroll, paying invoices, purchasing inventory — or even something as simple as keeping the lights on.

When cash is running low or you’d rather preserve your liquid assets, a working capital loan could be the answer. This type of loan can help your small business meet expenses head on so you don’t miss out on an opportunity to grow.

Working capital loans aren’t all created equally, however. This guide breaks down the basics of working capital loans, including where to find them and how to determine which loan offer is the best fit for your business. Continue reading to learn:

• What a working capital loan is
• What you can use a working capital loan for
• What the pros and cons of working capital loans are
• How to compare working capital loan options
• How to improve your chances of getting approved for a working capital loan

Working Capital Loan Fundamentals

Generally speaking, working capital loans are designed to finance a business’s everyday operations. These loans generally have a shorter life span, meaning you’re expected to repay them relatively quickly, typically less than a year.  Working capital loans are intended to meet immediate needs rather than fund long-term goals, such as a large-scale expansion or a major equipment purchase.

With that being said, working capital loans can be used in a number of ways. Here are some example scenarios of how a working capital loan might come in handy:

• You run a retail store and you need to hire temporary employees to handle the upcoming holiday sales rush. Instead of draining your cash reserves, you decide to use a working capital loan to cover the cost of hiring and training the additions to your staff.
• It’s time to renew your business’s insurance coverages and the premiums have gone because you added additional employees over the last year. You have cash on hand but you need it to pay for your utility bills so you get a working capital loan to keep your insurance up-to-date.
• One of your vendors is planning to discontinue a specific product so they offer you a bulk order at a significant discount. You run the numbers and determine that the profit you could make from selling the extra inventory could easily cover the cost of obtaining a working capital loan to purchase it.
• You need to purchase some essential supplies for your business but you have a slew of customers with outstanding invoices. You find an invoice financing lender who’s willing to offer you the working capital you need until those invoices are paid.
• Your business makes custom t-shirts and you get an unexpectedly large order that needs to be cranked out quickly. A working capital loan can be a lifesaver if you need to cash to buy materials or pay your employees overtime to get the order completed on schedule.
• Traffic has slowed down a bit and you think revamping your marketing strategy would help drive new customers to your business. You opt for a working capital loan to launch a brand-new ad campaign.

These scenarios are very different but the premise is the same. Working capital loans fill temporary funding holes so that you’re able to continue with business as usual.

What are the pros and cons of working capital loans?

In terms of the advantages of working capital loans, there are several to consider. First, there’s the speed and convenience of funding if you’re applying for a loan through an online lender.

Bond Street, for example, can fund a term loan for working capital within a week. The application process takes just a few minutes and approval decisions are typically made within 48 hours. If you were to apply for a working capital loan through a bank, the wait may be much longer. That could be detrimental to your business if you need financing quickly (which is often the case).

Another benefit is a shorter repayment term. Instead of tying up your cash flow for five or 10 years, you can repay a working capital loan over a period of months. Bond Street offers an intermediate term loan with a repayment term of one to three years if you need a bit more time.

Working capital loans are also appealing for entrepreneurs who don’t want to sacrifice any ownership in their business. If you were to seek funding from an angel investor or venture capital firm, for example, you’d be expected to hand over a percentage of your equity in exchange.

On the flip side, there are some potential drawbacks. The lender you work with may require collateral to secure the loan. Alternately, you may have to sign a personal guarantee or agree to a UCC lien on your business assets. In terms of the interest rate, an online lender may charge significantly more than a bank, particularly if you don’t have the best credit. These are all considerations to keep in mind as you research and compare your options.

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Comparing Working Capital Loans

When you need working capital, you have several options to choose from. The type of loan you that’s going to work best for you largely depends on the type of business you have.

1. Merchant cash advance

In the simplest terms, a merchant cash advance involves borrowing against your business’s future debit and credit card receipts. The lender provides you with a lump sum of working capital and you hold back a percentage of your daily debit and credit sales for repayment.

Merchant cash advances can put working capital in your hands quickly. Typically, it’s possible to borrow anywhere from 50% to 250% of your business’s credit card transactions. There is a downside, however. The annual percentage rate (APR) can easily climb well into the double-digit range, making this a potentially expensive choice for working capital.

Merchant cash advance lenders use a factor rate to determine the cost of borrowing. This rate can range from 1.15 to 1.5 and the higher the rate, the more expensive the loan. Here’s an example.

If you need an advance of $20,000 and you have a factor rate of 1.2, you’d repay $24,000 altogether. Assuming you have $20,000 in credit card sales each month and you commit 15% of daily sales to repaying the advance, it would take you 240 days to pay it off. The total financing cost would be $4,000 and the APR would work out to 57%.

2. Invoice financing

Invoice financing applies a similar principle, although with this type of working capital loan, your unpaid invoices serve as the collateral. Like a merchant cash advance, funding turnaround is fast and the repayment term is short.

Business owners may pay a premium for that speed and convenience, however. Invoice financing also uses a factor rate to determine interest. The factor rate for invoice loans can range from 0.5% to 5%, depending on the lender and the amount you’re borrowing.

Let’s say you have an outstanding invoice for $10,000. The invoice factoring company advances you $8,500 of that and holds the remaining $1,500. After 30 days, your client pays up so you repay the lender. They return the $1,500 in reserve to you, less a $300 fee, which amounts to a 42.35% APR.

3. Term loans

Term loans can be used for a variety of purposes, including providing working capital. For example, you could use a term loan to upgrade your business’s website or pay your suppliers for the month.

Borrowing limits tend to be generous. With Bond Street, for instance, you can get up to $1 million to cover working capital needs. Interest rates start as low as 6% for qualified borrowers. In general, the APR range for term loans maxes out at around 30%. Compared to the rates for a merchant cash advance or invoice financing, a term loan may be less of a strain on your bottom line.

4. SBA loans

Small Business Administration (SBA) loans are a popular choice for businesses that need working capital for two reasons. First, the borrowing limits are high. The SBA’s 7(a) loan program, for example, allows eligible businesses to borrow up to $5 million. Most online lenders limit borrowers to $500,000 or less.

Second, SBA loans offer some of the lowest interest rates you’ll find for a working capital loan. SBA SmartBiz loans, for instance, feature rates of 6.25% to 7.25%. If paying the least amount of interest is a priority, this type of loan may be more appealing than the other working capital options mentioned earlier.

There is a slight hitch, however. It can take weeks or even months to get an SBA loan funded. When time is of the essence, choosing one of the alternatives is likely to going to make more sense for your business.

Evaluating working capital loan options

Asking some key questions can point you towards the working capital loan that’s going to be most appropriate for your business. Here are some things to consider as you’re researching various lenders:

• What kind of APR and fees does the lender charge?
• What are the repayment terms? Will the loan be repaid daily, weekly, monthly, etc.?
• What will this loan be used for?
• What’s my cash flow like?
• How much do I need to borrow?
• How quickly do I need funding?

Taking a look at how working capital loans measure up can make it easier to narrow down the field.

Getting Approved for a Working Capital Loan

Every lender has its own set of criteria that they use to approve businesses for working capital loans. Broadly speaking, most lenders consider a combination of:

• Your personal and/or business credit scores
• The length of time you’ve been in business
• Your annual revenue

With some lenders, it’s possible to qualify for a working capital loan with a credit score below 500 as long as you have sufficient revenue and you’ve been in business for a year or more. Other lenders will make working capital loans to businesses with less than a year of operating history — if your personal credit score is above the 500 mark.

Some lenders cater to more established businesses. Bond Street prefers to work with entrepreneurs whose businesses are at least two years old and have $200,000 or more in annual revenue. Business owners who have a personal credit score of 640 or better are most likely to qualify but credit isn’t the only factor that’s taken into account.

Regardless of which lender you choose, you’ll need to provide copies of your balance sheet and other financial statements when you apply. Checking your personal and business credit scores, reviewing your revenue, and organizing your financial documents can give you a better idea of which lender you have the best shot at getting a working capital loan with.