Close to 70% of small businesses use financing options, including business loans, to secure the funding they need to keep their doors open.
Are you considering taking out a loan for your small business?
If so, then you may have heard of working capital loans.
What are these loans, and how are they different from other types of business financing? How do you know if now is the right time to apply for one, and are you applying for one for the right reasons?
Which type of capital loan will work best for you?
This article is here to answer all of those questions and more.
What Are Working Capital Loans?
Before we get any deeper into the subject, let’s first ensure that you understand the basic definition of a working capital loan.
While you certainly need funding for a small business to make investments and other larger purchases? You also need to ensure that you’re making enough to cover your necessary expenses.
These include things like the ability to pay your employees, the rent on your office building, and ensure that you can buy the raw materials you need to create your products. If you’re selling services, working capital loans help you to make sure you can afford any equipment you use or keep the products you use in your daily business in stock.
Running out of money to finance the day-to-day operations of your business is, unfortunately, more common than you might think.
About 1/3 of small business owners say that they’ve taken on serious debt to ensure they can keep their doors open. This can lead to personal financial ruin — not to mention anxiety within your employees about potential layoffs or late paychecks.
Luckily, capital business loans provide a better way out.
Let’s quickly define the idea of working capital itself. Working capital is the difference between your business’s assets (cash) and your liabilities (debt.) Remember that assets don’t always have to be hard cash/profits.
They can also be invoices that you’re owed or even liquid assets you can sell. This is important, as you’ll note that not all your assets are as readily available as others.
Your working capital gives you a number when it comes to how much cash you have left on hand after you take care of all the payments you owe. The goal is always to have positive working capital.
However, that’s not always a possibility.
When to Apply for Working Capital Funding
It’s important to understand when the time is right to apply for working capital loans.
Now, let’s talk about some of the most common reasons why companies might apply for one.
First of all, you should apply for a working capital loan if you currently can’t afford to pay your employees. Be aware that, in some cases, you can end up legally owing your employees more than the missed paycheck was worth (in some cases, double) if you pay them late.
Not to mention that late payment is a severe hit to overall productivity and office morale.
You might also use working capital loans to help you deal with seasonal fluctuations when it comes to sales. Especially if you’re a bit of a niche product, you might find that you do the majority of your inventory for the year in only a few months.
Maybe you’re a Christmas tree farm, but need some extra cash to tide you over until next December. You might even be a frozen yogurt or ice cream shop, and know that profits dip during the colder months.
A capital loan can help to keep you afloat while you wait for those big paydays to come in.
In some cases, you might take out a working capital loan because you need to get ready for that seasonal rush. You know your inventory will be depleted during your busy season. However, you need cash to stock up on your products, so you have something to sell!
You may even use the loan to hire extra workers during your rush season.
You can also use these loans to buy needed equipment, help pay for an unexpected emergency, or even develop a bit of a cash cushion for your company.
What to Know About Working Capital Loans
There are a few other key things you need to know about working capital loans in particular.
In most cases, they have relatively short repayment periods. In the majority of cases, you’ll have only about one year to pay back your loan in full.
Remember that working capital funding isn’t meant to be used to finance down the line goals or even more substantial purchases. They should be used only to ensure that you can cover your daily needs.
This is why it’s so important that you never take out more money than you know you’ll be able to pay back within the payment period. We know that it’s tempting to do so, but trust us when we tell you that borrowing more than you need will only land you in financial hot water down the line.
You will also need to have (at least in most cases) a strong personal credit score to get approved for your loan.
There are lots of ways you can improve your credit score. However, especially if you’re applying for any business loan, you need to get serious about fixing your credit score as soon as possible.
Another thing you need to know about these loans?
The good news is that, especially with a strong credit score, you’ll be able to get reasonably quick approval. This is undoubtedly true if you make it a point to apply for your loan online.
Lenders understand that, if you’re in a position where you need to apply for capital loans, you likely can’t afford to wait.
Additionally, these loans mean that you won’t have to sell a percentage of your business to be able to keep your lights on. You’ll be able to keep your equity.
The Main Types of Working Capital Loans
Now that we’ve covered most of the basics concerning small business working capital loans let’s talk about some of your specific options.
Many people may not realize that there are many different types of working capital loans to choose from. Take a hard look at your finances and your current working capital to get a better fit for your needs.
Before you apply, determine that you need a loan. Consider if you’re able to cut costs elsewhere to avoid having to take on any debt.
If not, read on to learn how to make the right choice when it comes to capital loan types.
1. Small Business Administration Loans
One of the most common types of capital loans is an SBA loan, provided by the Small Business Administration.
The good news is that the amount that you can borrow is usually higher than with other capital loan types. (Again, we do want to caution you against borrowing more than you need.)
The borrowing limit goes all the way up to $5 million.
However, even though the borrowing limit is high, the interest rates aren’t. This is another reason why SBA loans are so popular.
In most cases, your interest rate will hover somewhere around less than 8%.
Of course, not everything with SBA loans is perfect.
You should expect to wait a few weeks, or perhaps even several months to get approved for an SBA loan. After all, with such high borrowing limits, they need to be sure you can pay it back.
2. Invoice Financing
Other types of capital business loans are invoice financing options.
Essentially, you are putting up unpaid invoices as collateral against the working capital loan. You know that you’re owed money from your clients — but sometimes, they’re slower to pay it than you’d like for them to be.
You can show the lender these unpaid invoices, and get approved for a loan on those terms. This is an excellent option for companies that often deal with inconsistent cash flow.
Unlike SBA loans, invoice financing usually comes with a shorter approval period. However, to get your cash as quickly as you’d like, you’ll likely need to pay a premium fee.
Additionally, your interest rate will vary based on how much cash you need to borrow. It will also be influenced by the number of invoices you have outstanding.
In most cases, the interest rate can range from 0.5% all the way up to 5%.
3. Merchant Cash Advances
This one is a bit tricky to understand, but the basic concept is that you can borrow against future credit and debit card sales.
The lender you’re working with will give you a certain amount of cash — in some cases, up to 250% of your company’s transactions on credit and debit cards. Once you start making these sales, a set percentage or amount will be repaid to the lender.
However, this type of loan comes with a high APR. If you know you’re going to make many credit/debit card sales quickly, this might not be a big issue. But if you’re a smaller or newer business, this may not be best for you.
As with the invoice financing, your interest rates will also be determined by a factor rate. This depends on how much cash you’re borrowing, and the prospective sales you’ll make.
4. Cash Flow Loans
Another option you might consider when it comes to getting working capital loans?
Cash flow loans, also known as short-term loans.
As the name implies, these loans do carry a somewhat shorter repayment period. Additionally, they’re a bit different from some of the other loans on this list because you’ll pay a fixed monthly repayment. Many business owners also love that these loans don’t come with specific interest rate charges.
Instead, they have set fees associated with the loan.
You’ll get a lump sum of cash. This means that a cash flow loan is a good move for businesses that need a more substantial amount of capital ASAP.
Finally, these loans are among the easiest on this list to get approved for. So, if you find yourself in a bind — even if you don’t have excellent credit — you should consider cash flow loans.
Other Things to Consider
There are a few other things you should ask yourself before you apply for a capital loan.
First of all, ensure that you have as accurate of a picture of your cash flow as is possible. Understand how soon you’ll need access to the cash the loan provides. Can you get paid in installments, or is a loan that gives a lump sum more to your needs?
What are you planning to use the loan for? Is a working capital loan truly the best fit for what you need?
Finally, have you evaluated all the fees associated with the loan to avoid surprises?
Ready to Apply for Working Capital Loans?
We hope that this article has helped you to understand the basics of working capital loans better.
Above all, make sure you understand the loan terms in full. Explore other options before you take out a loan, and ensure you’re not borrowing more than you truly need.
Looking for additional advice on how to lower your company’s debt? Want to understand more about the top business loans?
We’ve got you covered when it comes to all that and more.
Keep checking back with our resource center for more tips and tricks on how to save more, make more, and borrow the right way.
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