What Are Working Capital Loans: All You Need To Know
If you’ve been in business for any length of time, you know profitability is key to success. But if you’re not managing your working capital effectively, your business could sink before profitability can give it a chance to swim. So when your working capital falls short, is it time to consider a working capital loan?
What is a working capital loan?
A working capital loan is a loan that business owners obtain when they need funds to pay for the day-to-day operating expenses of their business.
But first, it makes sense to get an overview of what working capital is and how it’s calculate.
What is working capital?
Working capital is the amount of capital a business has on hand to pay its daily operating expenses. These operating expenses include:
- insurance costs
- property tax payments
- accounting and legal fees
- lease and rental payments
While people often think of working capital as cash, it also includes other current assets, such as accounts receivables, inventory and prepaid expenses.
Working capital is often used as one measure of a business’s financial health. It’s easy to see why: When a business doesn’t have enough working capital, it won’t be able to pay its day-to-day expenses. And if you don’t do something about it, it could turn into a recipe for disaster.
How to calculate working capital
Working capital is calculated according to the following formula:
current assets - current liabilities = working capital
This formula is also how working capital is defined: Working capital is the difference between a business’s current assets and its current liabilities.
Current assets are any assets that can be quickly converted to cash (with “quickly” meaning within the next 12 months), while current liabilities are short-term financial obligations (that is, they are payable within the next 12 months).
Example: Let’s suppose Neverland Enterprises has $750,000 in current assets and $500,000 in current liabilities. When you plug the numbers into the working capital formula, you get 750,000 - 500,000 = 250,000, meaning Neverland Enterprises has $250,000 of working capital to pay its daily operating expenses.
What is the working capital (or current) ratio?
Like working capital, the working capital ratio is a measure of a business’s financial health. It’s also calculated using a formula:
current assets ÷ current liabilities = current ratio
You may have heard that a working capital ratio of between 1.5 and 2.0 is ideal, but this is only a rule of thumb. Current ratio metrics are very industry specific. For industries with a slower working capital turn, such as agriculture and construction, a current ratio of 1.1 to 1.3 is fine. On the other hand, industries with a higher working capital turn, such as technology and financial services, should aim for a current ratio of 2.0 or more.
You also don’t want your working capital ratio to be less than one, as this means your current liabilities are greater than your current assets (meaning you’re in the negative when it comes to cash flow).
The importance of working capital and the working capital ratio
Let’s plug Neverland Enterprises’ numbers from the previous example into the working capital ratio formula:
750,000 ÷ 500,000 = 1.5
Neverland Enterprises has a working capital ratio of 1.5, indicating it’s a financially healthy company.
Now let’s take a look at Neverland Enterprises’ main competitor, Hook Industries. Hook Industries has current assets of $1.5 million and current liabilities of $1.8 million. Plugging Hook’s numbers into the formula gets us the following:
1,500,000 ÷ 1,800,000 = 0.8
With a working capital ratio of less than one, Hook Industries isn’t in great shape financially. But its current assets are double the value of Neverland Enterprises’. How can it be in worse financial health than its competitor?
The answer lies in the fact that working capital must be turned into cash. Without the necessary working capital converting to cash flow to meet its upcoming liabilities, Hook Industries is far more likely to go bankrupt. Accounts receivable that are stale (not being repaid) or inventory that is obsolete (not turning over) won’t help it meet its obligations.
This example illustrates the importance of both working capital and the working capital ratio as measures of financial health: Financial health isn’t just about profitability or revenues. It’s also about a business’s ability to pay its daily operating expenses as they come due.
How working capital loans work
Now that we’ve explored the concept of working capital, let’s take a look at how working capital loans work. Companies obtain working capital loans so they can have access to working capital today to pay their daily expenses. Remember, working capital has to be converted into cash flow. Often, this cash conversion process takes time (terms on A/R or time to move Inventory) and working capital loans help to bridge this timing gap.
A business might find itself without the cash flow necessary to pay the bills it has coming due. This might be the result of the seasonal nature of the business. But it’s something that can also happen even if you have large invoices outstanding.
For example, if these outstanding invoices aren’t payable by your clients for thirty days, you could find yourself in the tricky situation of not having enough funds to pay the expenses you have coming due over the next 29 days.
Types of working capital loans
There are several types of short-term financing that can function as working capital loans. While they’re offered by an assortment of lenders and providers and have various interest rates that cover a wide range, these loans typically require less time for approval. And since they’re meant to help you cover short-term obligations, they’re repayable over a shorter term than a standard loan — typically 12 months or less.
At Foro, we’re built a platform that could save you weeks of shopping around for the right working capital loan. To better understand your options, check out our overview of common loan types and terms.
Working capital lines of credit
With a working capital line of credit, you get a revolving credit line you can borrow from when you need, and you pay the borrowed amount back as current assets are converted to cash flows. Like a credit card, you can do this over and over again—the credit line remains open for you to borrow against, hence the “revolving” portion of the name.
Revolving lines of credit are typically secured by the tangible current assets (A/R & Inventory) with borrowers drawing at a designated advance rate. This allows a company to access cash immediately based on current assets that will be converted to cash in the short-term.
Without enough current assets (A/R & Inventory), it can be difficult to get approved for a working capital line of credit, but depending on their terms, they can be a great source of working capital funding. A line of credit with good terms can be invaluable even for businesses without cash flow timing gaps.
SBA CAPLines are lines of credit offered under the umbrella of SBA’s 7(a) loan program. They’re designed specifically to help businesses dealing with short-term or cyclical working capital needs, and offer affordable interest rates.
The drawbacks to SBA loans are that they can be difficult to qualify for and require additional documentation. The application and approval process can take quite a long time, which can render them impractical if your working capital needs are particularly immediate.
Invoice financing or invoice factoring
If your business sends its customers or clients invoices with payment terms, invoice financing or invoice factoring might be a viable working capital funding option. With invoice financing, you use your outstanding invoices as collateral for a line of credit. The SBA’s Working CAPline is an example of this kind of financing.
If you opt for invoice factoring, you sell your outstanding invoices to a factoring company at a discount of face value. This discounted rate is the servicing fee that the factoring company charges. In exchange, the company gives you a percentage of your outstanding invoices’ value (usually 75% to 85%, although there is no standard arrangement). One of the drawbacks to this arrangement is that the factoring company takes over collecting on the invoices from your clients.
Think of trade credit as a very short-term 0% financing arrangement best suited for import and / or export businesses. By obtaining trade credit, you can negotiate longer payment terms with your vendors and suppliers. It’s a way to have access to the supplies you need while nurturing your working capital by deferring the payment for those supplies.
Trade credit can provide short-term relief and give you some financial space to get your working capital back into good working order. However, it can be difficult to arrange if you don’t have a good relationship with your suppliers and a history of prompt payments.
Business credit cards
While not the ideal working capital funding solution, business credit cards can be helpful in a pinch, especially when it comes to bridging a very short-term cash flow gap. The downside to using credit cards as a working capital funding source is the high rate of interest.
On the upside, if you manage the transaction well, you may be able to take advantage of rewards or points. And your repayments will help boost your business’s credit profile, which can increase your chances of obtaining more traditional financing with better terms down the road.
Pros & cons of working capital loans
Working capital loans offer specific benefits which make them quite attractive for businesses facing timing gaps in cash flows.
Flexibility. Having a line of credit gives you the flexibility to convert working capital assets to cash today rather than waiting for the cash conversion process to complete.
Easier to qualify. Depending on the type of working capital loan you’re applying for, it may be easier to qualify than it would for other credit products.
Quick access to funds. And of course, you’ll usually get quick access to the funds you need, which is a definite plus if you’re grappling with insufficient working capital
Despite the pros of working capital loans, there are also some disadvantages:
Interest rate risk. Interest rates tend to be floating for working capital loans, which means that the interest rate is not fixed during the term of the loan. Therefore, the borrower assumes risk that market interest rates could change (higher or lower) during the course of the loan.
Collateral requirements. Working capital loan will require collateral with available funds limited to a percentage of current working capital assets.
Impact on your working capital ratio. Working capital loans are short-term loans that typically need to be repaid within a year. The repayment amounts will need to be included in your current liabilities, which can potentially have a negative impact on your ongoing working capital ratio.
How to acquire a working capital loan
The steps you’ll need to take to qualify for a working capital loan will depend on the type of funding you’re seeking. For example, a factoring arrangement or inventory financing will have different requirements than an SBA loan or a working capital line of credit.
However, there are certain steps you can take in preparation for working capital funding:
Assess the amount of funding you need. Calculate your working capital and your working capital ratio. Consider how much you’ll need to meet your upcoming financial obligations, and the amount you can repay each week or month.
Obtain qualification information. You’ll need to provide a summary of your current working capital assets (A/R, Inventory) as well as supporting business financial information. ]
Research and compare. Check out the lenders offering the type of funding you want. Compare their rates, fees, and repayment terms, and see what their qualification requirements are.
Is a working capital loan right for my business?
It can be difficult to determine if a working capital loan is the right solution for your financing needs. To help you decide, ask yourself the following questions:
Does my business deal with seasonal or cyclical dips in revenue? Working capital loans can be helpful for businesses that face seasonal or cyclical income fluctuations.
Is my business growing? If your business is poised to expand, working capital financing might be a potential source of funding for some of this growth, such as taking on larger orders from existing or new customers.
Is my business dealing with unexpected expenses? Whether it’s a machine in need of repair or some other unexpected cost, a working capital loan such as a line of credit might be the ideal solution, especially if you don’t have an emergency fund.
When considering a working capital loan, however, you should always evaluate whether you can meet the potential interest repayments. If you won’t have the funds to make the required payments, a working capital loan won’t be a viable financing solution for your business.
If this process sounds stressful or laborious, it doesn’t have to be. Foro’s process is simple and streamlined. You’ll spend five minutes filling out a guided business profile, which will be distributed to multiple financial institutions simultaneously. Within 48 hours, we’ll provide you with a list of lenders that are interested in talking to you.
How do you get a working capital loan?
Working capital loans are typically offered by banks and other financial institutions. You’ll need to provide information about your collateral, such as accounts receivable, inventory, or other current assets, and a detailed plan for how you intend to use the loan funds. The simplest way? Register wtih Foro and we’ll help you connect, compare and choose between the top financial institutions.
What is the interest rate range on working capital loans?
Interest rates on working capital loans vary depending on a number of factors, including the lender, the type of working capital loan, and the credit scores of the business and the business owner. Most often, working capital interest rates will be floating.
What is the difference between a term loan and a working capital loan?
Working capital loans provide short-term financing for a business’s day-to-day operating expenses, while a term loan is a business loan providing a lump sum that’s repaid over a set term.
When should you not get a working capital loan?
You should not get a working capital loan if you cannot afford to make the loan payments as scheduled.
About The Author: Belle Wong
Belle Wong is a freelance writer specializing in finance, tech/SAAS, small business and marketing. She spends her spare moments testing out the latest productivity apps and plotting her latest novel. Connect with Belle on LinkedIn.