Working capital loans provide short-term financing that small business owners can use to cover operational costs. They are often leveraged by seasonal businesses that need to stock up on inventory and supplies during certain times of the year, along with those that need a one-time emergency infusion of cash to pay expenses and deal with cash flow issues and other short-term needs.
Working capital financing comes in many forms. These include bank loans, term loans, lines of credit, US Small Business Administration (SBA) loans, and invoice factoring.
Understanding what these financing options are and how they work can help you understand whether your business should apply for one and which type you should get.
In this article, we’ll explain everything you need to know about working capital financing.
Working capital loans: The basics
A working capital loan provides financing a business can use to pay for day-to-day operational expenses over a short timeframe. This could include things like:
- Covering payroll
- Making debt payments
- Restocking inventory
- Paying rent
- And more.
Working capital loans are offered by traditional banks, along with credit unions, online lenders, and other financial institutions. Annual percentage rates (APRs) for working capital loans are typically lower than for longer-term business financing options, which come with higher interest rates. Requirements to qualify for working capital loans are sometimes less strict than for long-term business loans, especially for online lenders.
A working capital loan is often smarter than using business credit cards for short-term financing needs. Credit cards usually have much higher interest rates.
Uses for working capital loans
Small business owners who are finding it challenging to pay for day-to-day operational costs or business expenses like inventory, payroll, and supplies — whether for seasonal or emergency reasons — often turn to working capital loans for relief.
Tip: Businesses should never use working capital loans to pay for long-term expenses like expanding a business, remodeling a location, or financing equipment. The terms, interest rates, and conditions aren’t favorable for longer-term use.
Here are examples of situations where a working capital loan could be helpful:
- Your clients are late paying their bills. You have more outstanding invoices than usual. You’re finding it impossible to completely cover payroll and rent because of it. A business working capital loan or invoice factoring could help you pay those expenses.
- You own a nursery and garden center. Last year’s sales were mediocre, but this season promises to be a banner one. You’re short of cash to buy plants and other inventory because last year was such a bad one. A working capital loan will give you money to invest in inventory and you can pay it back once you generate sales.
- Your business sells products that it manufactures itself. You’re currently short of manufacturing dollars and not having new products within the next month could have a negative impact on your customer experience and the bottom line of your operation. A working capital loan could help you get through your manufacturing crisis.
Types of working capital loans explained
There are several types of working capital financing and it’s likely you can find one that meets your specific business needs.
Term loans are typically offered by banks, online lenders, alternative lenders, and other types of financial institutions. They have to be paid back within a defined period of time. For working capital loans, this is typically a few months to two years, although loan terms can extend up to 25 years. Loan amounts can range from $2,000 to $500,000. Interest rates start at six percent and go up from there, depending on the purpose of the loan, creditworthiness of the borrower, the lender, and more. It is possible to find interest rates greater than 50 percent offered to desperate businesses with poor credit by sketchy lenders. Think twice before agreeing to a working capital loan with unfavorable terms. They’re often all it takes to put a business under.
Business line of credit
Small business owners can get business lines of credit through real world and virtual banks and other types of financial institutions. The lenders approves an amount of money the business can draw against when they need to, including for the scenarios outlined in this article. The money is typically available for five years. Limits for a business line of credit typically range from $2,000 to $250,000. Interest rates start at about ten percent and go up from there. Limits and interest rates are based on the business type, funding needs, credit score, and more. The good news with a business line of credit is that you don’t pay interest on it until you draw funds from it. Plus you can always rest assured knowing you have cash on hand any time you’re facing a business emergency.
Small Business Administration (SBA) loans
SBA loans are backed, in part, by the United States Small Business Administration. The intent of the program is to support small business owners as they start, maintain, and grow their businesses. There are many different types of small business loans available through the SBA developed for different purposes and applicant types. Each comes with its own loan limits, terms, and interest rates. Examples of SBA loan options that can be leveraged for working capital purposes include:
- SBA 7 (a) loans. This is the Small Business Administration’s primary loan program. Loans are available through it for up to $5 million. The money can be used for working capital, along with other things including buying real estate, refinancing debt, purchasing business equipment and supplies, and more. Interest rates on SBA 7(a) loans usually range between five and ten percent.
- CAPLines. These loans are part of the SBA 7(a) program. They are working capital lines of credit offered through the Small Business Administration. They were developed to provide small businesses with working capital for short-term, seasonal, or cyclical needs. Borrowers can choose from:
- Contact CAPLine loan
- Seasonal line of credit
- Builder’s line of credit
- Working capital line of credit
All the options come with a $5 million limit and a maximum 10-year repayment term. A representative at an SBA-approved bank or loan provider can help you figure out which option is best for you.
- SBA microloans. These loans are available to startups, new businesses, and growing operations to help them get off the ground or expand. Nothing in their rules says the money from them can’t be used for working capital purposes. However, the funds are typically used to purchase equipment, machinery, inventory and supplies, and for operational expenses. Microloans are available for up to $50,000. Interest rates are higher than for other SBA offerings, ranging between 8 and 13 percent. The higher rates are because newer businesses are usually not as creditworthy as more established ones.
One of the limits of using SBA loans outside of the CapLines program for working capital emergencies is that the application and approval process can be a long one and you may not get your money in time. If you have questions about SBA loans, check out the FAQs on their website.
Invoice factoring allows you to sell your outstanding business invoices to an outside invoice factoring company. The “selling price” is usually 5 to 15 percent of the outstanding amount of the invoices. Once you transfer the invoices, the factoring company is responsible for collecting on them.
While you’ll lose a percentage of the value of your invoices if you sell them to a factoring company, it could be a reasonable solution for companies that are experiencing a significant accounts receivable problem. It relieves the pressure of getting invoices paid, provides fast cash, and bypasses the process of applying for a loan through a traditional bank or loan provider. However, your customers might not like the experience of being contacted by a factoring company demanding payment.
How to apply for working capital financing
How you get a working capital loan or line of credit depends largely on the type of financing and the lender. However, there are a few steps they all have in common. These include:
- Figuring out your borrowing needs. If you think you need a working capital loan or line of credit, take some time to figure out how much money you want to borrow and for how long. Determine whether you need a one-time infusion of cash or money on an as-needed basis. Also, figure out how much you can afford to repay each month. It’s important that you consider all these factors. Getting financing puts your business at risk and you must take doing so seriously.
- Check your business and personal credit scores. You need to do this because loan providers will check your credit history before they approve a loan application. You’ll need a personal FICO score of between 530 and 550 to qualify for working capital financing. It takes a score of 600 or higher to earn better interest rates and terms.
- Research lenders. Check out different types of lenders that are able to supply the type of financing you need. This could include different banks, credit unions, and online lenders. Compare interest rates, repayment terms, prepayment penalties, whether you have to put up a personal guarantee, application costs, and other fees. Also, do some research to ensure any lender you’re thinking about working with is legit and financially sound. Also, check online ratings and reviews to find out if you’re likely to have a good borrower experience. You’re probably under financial pressure if you’re considering a working capital loan. Still, you owe it to yourself to do your due diligence. Skipping it could end up costing you and make your situation worse.
- Pull together your paperwork. Most lenders will require you to submit some documents with your application. These could include:
- Information related to existing business loans
- 12 months’ worth of personal and business bank records
- Two years of tax returns
- Proof of identity
- A copy of your latest business plan.
- Apply for financing. Your prospective lenders will require you to complete a formal application, either online or in person. (Be wary of any lender that doesn’t have a formal, complete, and thorough application process.) Your lender may ask you for additional information if your application is incomplete.
Review your final offer. If you’re approved for a loan, make sure the terms, interest rate, and everything else meet your expectations. Read all the fine print. If you’re unclear about anything, ask questions. The future of your business could depend on it.