Working capital loans are designed to fund a company’s day-to-day operational expenses, such as inventory purchases or supplier payments. These types typically carry short repayment terms, and aren’t intended for to finance long term business needs like major renovations, large scale expansion projects or equipment purchases.
Before we jump into the uses and types of working capital loans, let’s briefly touch on two relevant key concepts: working capital and working capital liquidity.
- Working capital: Working capital refers to the money that a company uses to manage its everyday expenses. Cash flow is often called the lifeblood of a business – and for good reason, as even profitable ventures can run into trouble if they aren’t able to meet their short term financial obligations. It can be tricky for small business owners to strike the right working capital balance – having enough such that their daily operations run smoothly, but to avoid having excess cash lying around where it can be put towards more productive uses.
- Working capital liquidity: It’s important to keep your working capital liquidity in mind, so that you’re aware of how much of your working capital is available for use. That’s because your current assets may not all be in the form of cash. For example, a portion of your current assets may be tied up in inventory or accounts receivable. As such, it’s important that small business owners get a sense of their weekly cash flow so as to avoid running into payment issues or missing out on business opportunities.
Common uses for working capital loans
Depending on your business, as well as the industry you’re in, there can be a variety of working capital needs. Below are common reasons why small business owners obtain working capital financing:
- Capitalise on time-sensitive business opportunities: With external financing, you’ll be better positioned to capitalise on business opportunities that you may otherwise have to pass on – such as making bulk purchases to take advantage of supplier discounts, or investing in expansion activities that’ll help your company grow.
- Manage seasonal fluctuations: It’s not uncommon for seasonal businesses to rely on working capital loans to even out their cash flow across the high and low seasons. For example, to prepare ahead for the busy season, a restaurateur may obtain external financing to cover the costs of inventory purchases, marketing activities and hiring temporary staff.
- Purchase equipment or software: Having up-to-date equipment and software can help bring about productivity gains for your company in the medium run – yet the may be too costly to bear upfront. With a working capital loan, you’ll be able to obtain the tools you need without putting a dent to your cash flow. Note: We aren’t referring to major equipment purchases – such as manufacturing machinery – here as these purchases typically require long term financing solutions. We’ve included more information about distinguishing between short term working capital needs and longer term financing needs below.
Types of working capital loans
With the rise of alternative lenders, a wider range of financing solutions are now made accessible to small business owners. Here’s a quick overview of common types of working capital loans available:
As its name suggests, short term loans are lump sum loans set to be repaid within a short period of time – typically six months. The loan will be repaid in regular installments, along with the lender’s fees and interest.
Compared to long term loans, short term loans offer lower maximum loan amounts and carry higher interest rates. These loans often come with more flexible lending terms and are easier to qualify for, and are therefore a great financing option for newly established ventures.
A line of credit, also commonly known as revolving credit provides business owners with access to a pre-approved sum of capital. It helps to think of a line of credit as a credit card; it’s a facility you can draw from as and when you need, and interest is charged only on the amount that is drawn. When the amount drawn is repaid, your credit limit goes back up.
Invoice financing is a short-term financing solution that enables businesses to borrow based on their unpaid invoices. By using your accounts receivables as collateral, you’ll obtain an advance of between 70 to 90 percent of your outstanding invoices through your lender. Once your customers pay up their invoices, you’ll receive the remaining balance (less the factor and processing fees).
A merchant cash advance (MCA) isn’t a loan, but rather a lump sum payment that a MCA provider advances based on your credit card transactions. You’ll then hold back a percentage of your daily or weekly credit sales until the full repayment has been made. It’s a financing option that lends itself to businesses that receive the majority of their payments through credit cards, such as restaurants, beauty salons and retail companies.
Which working capital loan is right for my small business?
Working your way through a checklist of key pointers can help you better determine which financing solution will be a good fit with your needs. Below are some questions and pointers to include in your list:
How quickly do I require funding?
Depending on your loan purpose, you may or may not be able to wait for several weeks to gain access to funding – as is the case for situations such as urgent equipment repairs, or when you require external financing to fund a large scale business project.
In these scenarios, traditional lenders may not be a good fit, as these lenders tend to have rigorous application processes and lengthier onboarding periods. It’s not uncommon for businesses to have to wait several weeks to hear back about the status of their loan application.
Will the loan improve my business’ financial position?
Certain types of financing solutions, such as merchant cash advances carry hefty fees and may require daily repayments. As such, things may quickly spiral out of control if small business owners aren’t able to keep up with the payments – and they may wind up in a debt spiral, taking out multiple loans in succession in order to pay off the outstanding balance on previous advances.
Before you commit to a loan, you need to be absolutely sure that you’ll be able to meet the repayments in a timely manner – and that the benefits it brings to your business outweighs the costs.
Do I understand the real cost of the loan?
As with any kind of business loan you choose to take up, it’s essential that you pay close attention to the repayment terms, and fully understand all possible fees you may be liable for. Always request for a full breakdown of the fees involved, and keep an eye out for terms that allow for changes in the interest rate, as well as loan acceleration clauses.
What’s the ROI of the loan?
While obtaining external financing can be key for growth, it may not be a good fit for your business depending on your current situation and financing needs. “Will borrowing earn me more money than it costs?” is an important question you’ll need to answer to assess the ROI of the loan.
Ideally, you should be using the funds obtained for investments or activities that will produce growth or revenue, or create a significant reduction in your costs – such as inventory purchases or equipment repairs – and not expenses like office renovations, as these will produce a negative ROI.
Don’t confuse short-term working capital needs and longer-term business financing requirements
Simply put, working capital is used to pay off short term obligations, while long term financing requirements are related to investments or activities that impact upon the long term growth of your company – such as major renovations, expansion to a new location or equipment purchases.
Distinguishing between these two types of financing needs is key, so as to avoid running into problems that may arise from choosing financing solutions that aren’t a good fit for your needs.
Here’s an example: A line of credit is best suited for short term financing needs, due to the flexibility it offers – business owners can draw from the line at anytime, and there aren’t restrictions imposed on what the funds can be used for. However, if a borrower were to use up the line for longer term expenses, this will limit his or her access to financing should urgent expenses arise out of the blue.
Tips to help you get approved for your working capital loan application
Getting a working capital loan? Below, we’ll share a few tips that’ll give you a leg up in getting your application approved:
Provide a good reason and clearly defined use case for the loan
There are a variety of reasons why you need to provide a clearly defined loan purpose: it allows your lender to assess if the loan will be a good fit for your business (or to suggest alternatives that would be a better fit) and to evaluate if your business will make a good investment.
To foster trust with your lender, you’ll need to show that you have a clear plan for your funds and how it contributes to the growth and success of your venture. For example, if you’re obtaining funding for marketing activities, it helps to prepare a summary of your marketing strategy, highlight past projects and strategies that have been successful and indicate how you’ll be using the loan to further replicate these successes.
Clean and clear accounting in bank statements
Lenders want to see a clean bank statement – one that shows regular deposits, a healthy bank balance and no overdrafts – as it’s an indicator that you’re on top of your business finances, and will likely make a reliable borrower.
If you’ve had an overdraft, it doesn’t mean that you’ve blown your chances at getting your loan application approved. Be prepared to explain why you applied for an overdraft; you’ll need to provide background information on the situation and why you need access for the funds, along with details such as the dates and account number. Highlight that this is a one-off incident, and show how you’ve implemented measures to prevent similar incidents from occurring.
Provide documents that support your cash inflow projections
In reviewing your cash inflow projections, lenders want to assess that these projections are realistic and aren’t too far off the mark from industry benchmarks or your historic performance. In addition, they’re also looking to see if you’ve left a reasonable amount of wiggle room, such that you’re able to meet your loan repayments when unforeseen expenses crop up.
Therefore, it’s important that you include documents that will support your cash inflow projections in your application, such as recent invoices, aged list of debtors, evidence of confirmed orders or contracts, up-to-date management accounts and transactional data (for B2C businesses).
Build up your personal credit score
For small businesses – in particular newly established ventures without a solid credit history – your personal credit score is an important factor of consideration when lenders assess your loan application. That’s because it’s an indicator of how reliable you are with your financial obligations; if a business owner has a pristine personal credit record, it’s safe to assume that he or she will be on top of their business finances too, and be timely and consistent with their working capital loan repayments.
To sum it up…
- Working capital loans are designed for short term financing needs. Small business owners typically obtain these loans to capitalise on time-sensitive business opportunities, manage seasonal fluctuations or to create a cash cushion.
- Common types of working capital loans include: short term loans, invoice financing, business lines of credit and merchant cash advances.
- Running through a checklist of essential pointers is critical for helping you evaluate loan options that will best meet your needs. Some key questions you’ll need to ask yourself include: “How quickly do I require funding? What’s the ROI of the loan?”
- To improve your chances of getting your loan application approved, here are several tips you can implement:
- Provide a good reason and clearly defined use case for the loan
- Have clean bank statements
- Provide documents that support your cash inflow projections
- Your personal credit score holds weight in your lender’s decision to approve your application, so you’ll need to work towards building it up if your personal credit score isn’t yet where you want it to be.