Definition & Guide To Working Capital Loans For Small Businesses
Running a small business is no small feat, and at one point or another, most (if not all) businesses need to take out a loan for one reason or another. And in your research of business loan options, you’ve probably come across something called a working capital loan, and now you’ve got questions.
What is a working capital loan? Do you need one for your business? What can you do with a working capital loan? Are there different types of working capital loans? What can you expect in terms of working capital loan requirements and rates?
All good questions that we are going to address here, so keep reading to get a quick understanding of working capital loans.
Table of Contents
- What Is A Working Capital Loan?
- Types Of Working Capital Loans
- Working Capital Loan Rates & Requirements
- Reasons To Get A Working Capital Loan
- Next Steps: Best Working Capital Loans For Small Businesses
What Is A Working Capital Loan?
To begin, you’ll first need to know what working capital loans are. There are a lot of ways to describe them, but we’ve boiled it all down to an easy-to-understand working capital loan definition: Working capital loans (also known as operating capital loans) are used to keep your everyday business operations up and running.
Essentially, they’re designed to help your short-term cash flow by providing your business — you guessed it — more working capital. As such, working capital loans can be particularly useful for seasonal businesses or those that tend to do most of their business in periodic bursts rather than steady sales. Examples of expenses you can use a working capital loan for include:
In fact, you can use a working capital loan for the majority of your business expenses. Typically your lender will outline any restrictions on how you can use your loan.
Types Of Working Capital Loans
Working capital business loans come in many different forms. Which kind of loan is right for your business will depend on your needs and financial situation.
Here are some common types of capital loans:
- Installment Loans: Installment loans (sometimes known as term loans) are issued to borrowers in one lump sum. Borrowers are then expected to pay back that amount, plus interest, in regular fixed installments. These tend to be the types of contracts that people think of when they think “loan.”
- SBA Loans: These are installment loans that are partially guaranteed by the Small Business Administration, which grants businesses better rates and terms than they’d otherwise be able to access. The most popular is the 7(a) loan, which can be used for many business purposes, including working capital. Because SBA loans are government-backed, they can be much more difficult to qualify for, and the application process is lengthy.
- Lines Of Credit: With a line of credit, you get access to a certain amount of money called your credit limit. You can draw from this line of credit at any time, up to your credit limit. Often, lines of credit are revolving, meaning as you pay off your debts, you can draw from the funds again. A working capital line of credit can be a great way to achieve a more consistent cash flow.
- Short-Term Loans: Short-term loans (also sometimes called cash flow loans or fixed-rate loans) are issued to borrowers in one lump sum and are paid back in regular fixed installments over a short amount of time. Unlike installment loans, short-term loans have fixed fees instead of interest charges. Generally, short-term working capital loans are also easier to qualify for than medium- or long-term loans, making them a good option for young businesses.
- Invoice Financing: Invoice financing is a catch-all term for invoice factoring and loans in which invoices are used as collateral. Both options allow you to utilize unpaid invoices to access immediate funds for working capital. In other words, if you have a B2B business that struggles with inconsistent cash flow due to slow-paying customers, invoice financing could be beneficial for your business.
Working Capital Loan Rates & Requirements
Working capital loan rates and eligibility vary with every loan provider, but here is an idea of the type of rates and borrower requirements you can expect from each type of working capital loan:
|Alternative Installment Loans||6%-36% APR||• At least one year in business
• At least fair credit
|SBA Loans||6%-11% APR||• At least 2 years in business
• At least fair credit
• Strong business financials
|Lines Of Credit||7%-65% APR||• Available to businesses of many sizes and credit scores|
|Short-Term Loans||6%-99% effective APR||• At least 3 months in business
• Consistent cash flow
• Poor credit okay
|Invoice Financing||1%-6% of the invoice value per month||• Must have unpaid invoices|
Note that while some types of loans have APRs, others have “effective APRs.” This is because loans with flat rates don’t have interest rates; instead, all of the interest is front-loaded into the flat rate. Still, it’s possible to make an approximate comparison using our short-term business loan calculator tool.
As far as eligibility goes, lenders are usually interested in these three primary factors, though not every lender cares about all three, and many will have additional qualifications:
- Time In Business: The longer you’ve been in business, the easier it usually is to get a loan.
- Credit Score: The better your credit score, the easier it is to get a loan and a better rate.
- Revenue: Lenders use your monthly or annual revenue to get a sense of how much debt you’re able to service.
Reasons To Get A Working Capital Loan
Depending on your business and industry, there can be many different reasons to get a working capital loan. Here are some of the most common reasons to get a working capital loan.
1) Inconsistent Cash Flow
If your customers take a long time to pay invoices or your inventory takes a long time to turn over, your business’s cash flow will suffer. Inconsistent cash flow can make it tough to pay bills on time and run your business. A working capital loan gives you access to cash when you need it.
2) Seasonal Sales Fluctuations
Working capital loans can come in handy for seasonal businesses that need to pay business expenses while sales are slow. For example, a boat tourism company may take out a working capital loan in the winter to help cover expenses during the off-season.
Seasonal businesses might also use working capital loans to purchase inventory before a holiday rush to prepare for increased sales.
3) Business Growth Spurts
It’s no surprise that startups and young businesses can have difficulty making ends meet. Working capital loans help new businesses cover everyday expenses, pay their employees, hire new employees, and invest in growing and marketing their businesses.
4) New Business Opportunities
Nothing is worse than passing up on a huge business opportunity because you don’t have the funds. A working capital loan can help you purchase new equipment, invest in training, or give you the resources you need to expand your business and take advantage of opportunities when they arise. Working capital loans can also allow you to take on projects that are a good investment in the long run but may not have an immediate payoff.
5) Cash Cushion
If your business doesn’t have much wiggle room for unanticipated expenses, working capital can act as a cash cushion or emergency fund that helps ensure that your business can deal with the unexpected.
6) Paying Higher Interest Debts
Interest rates and promotional offers can vary from moment to moment. Sometimes, it may make sense to borrow at a lower interest rate to pay off higher-interest debts. You should always do this with caution, however, particularly when you’re dealing with loans that have flat rates.
Next Steps: Best Working Capital Loans For Small Businesses
Now that you have a better idea of what working capital loans are and what they can do for your business, you may want to start investigating specific loans and loan offers. You’ll find no shortage of them online, but if you’re looking for a place to start, check out our article, Best Working Capital Loans For Small Businesses.