Working capital is a term used to describe the financial resources available to your small business at any given moment. Maintaining a healthy amount of working capital helps your business to function, grow, and take advantage of opportunities as they arise.
Small business owners know how difficult basic operations become if there’s even a slight pinch in cash flow. Boosting working capital with a sensible loan program puts those small businesses in a position to grow.
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Every business needs cash on hand to pay for unavoidable operational costs. Think of all the operational expenses every business owner can expect: inventory, employee salaries, rent, insurance, utility bills, office supplies, marketing, and debt payments. That doesn’t even factor in unexpected expenses like equipment breaking down, sudden inventory opportunities, or surging prices for things like gas or electricity.
Working capital is the cash your business has on hand to pay for its expenses, unexpected and otherwise. It includes not just the actual liquid cash, but also accounts receivable and any existing inventory that can be easily liquidated.
To get an idea of your small business’s working capital situation, you can examine your net working capital and your working capital ratio.
Calculating Net Working Capital (and What it Means)
First, you can calculate your net working capital. Your net working capital is the total amount of working capital your company has on hand. Note that in this calculation, both liabilities and assets are calculated in the short term, typically over the course of one year.
You’ll need to add up all your business’s current assets and cash to find your net working capital. That means totaling your cash, your accounts receivable, your supplies, your inventory, investments you might have, and any other assets that are easily liquid. For example, let’s say those assets add up to $100,000.
Next, calculate your company’s total current liabilities. That’ll include accounts payable, ongoing expenses, taxes due, debt payments over the next year, and every other cost you know you’ll need to pay over the next year.
Finally, subtract those liabilities from your current assets and cash. That’s your net working capital. How much money do you have left over after you pay for all of your expenses in the next year?
If the example company’s liabilities add up to $80,000, that means that their net working capital is $100,000 – $80,000, or $20,000.
Calculating Your Working Capital Ratio (and What it Means)
It’s important to know your net working capital, but that number doesn’t necessarily give a full picture. Judging your company’s financial health via net working capital alone is like judging the score of a basketball game by looking at one team’s score on its own. Sure, it tells an important part of the story, but you’re missing vital context.
A working capital ratio shows small business owners the ratio of assets to liabilities. To calculate it, take the same numbers as above for assets and liabilities, and this time divide the assets by the liabilities instead of subtracting. In this case, $100,000 divided by $80,000, or 1.25.
Generally, the higher your working capital ratio, the better your financial situation. A higher ratio means that your company is well-equipped to make necessary payments in the short term, and can potentially take on additional debt.
At the end of the day, a higher net working capital amount and a larger working capital ratio mean that a company is well-positioned to fund its short-term needs. These companies are in a prime spot to develop new products, grow, expand, or even seek out additional business funding.
Why Do I Need a Working Capital Loan?
If either of those numbers is particularly small (a working capital ratio below 1.2 is typically considered small), you may want to consider financing options for adding additional working capital. If your working capital ratio is small, you might not be able to hire additional staff, stock up on inventory if there are supply chain issues, or make an unexpectedly large utility payment.
Imagine you own a company specializing in building patio furniture. If word spreads about your furniture and demand grows, you’ll need to buy more lumber. You’ll need to pay more to transport your furniture, and you may want to hire additional craftsmen to help build more of it. Each expense in this example leads to growth – more sales, more product, etc. – but it all costs money, and paying for everything necessary for growth can cripple cash flow in the short term.
Working capital financing alleviates that issue. Seeking out small business loans specifically intended to provide additional working capital means filling in cash flow gaps and giving your company the financial maneuverability necessary for growth.
In short, making sure that you’ve got sufficient business working capital means making sure that you’re ready to grow and expand.
Types of Working Capital Loans
Meeting working capital needs means that these forms of business financing are often shorter-term than other forms. You don’t want to take out a 15-year loan to cover a shortage in working capital needed for typical business expenses. With that in mind, there are several types of financing most typically used for working capital.
Many financial institutions offer short-term loan options for working capital. Short term loans are doled out as lump-sum deposits from lenders who are repaid with monthly payments. Interest rates are typically higher than they are on long-term financing, depending on the creditworthiness of the borrower. A typical short-term loan will also be smaller and have repayment terms usually lasting less than 18 months.
There are some significant upsides to these loans. Because of their smaller sizes and the fact that they’re often used to help in cases of emergency, short-term loans often feature streamlined application processes and are typically moved quickly. They’re also often offered by a wide variety of financial institutions, from banks and credit unions to alternative online lenders (like iCapital Funding) who can get you the funding your business needs quickly.
Working Capital Lines of Credit
Financial institutions often offer working capital lines of credit, which are effectively reserves of cash to be used when needed. With lines of credit, you’ll only pay interest on money borrowed under a credit limit.
Working capital lines of credit can be excellent options to have in your back pocket for when those unexpected expenses pop up. If something breaks, a supplier is offering a considerable deal on a necessary supply, or you experience a slow month, having a line of credit means you can handle those expenses and pay minimal interest. Working capital lines of credit can be both secured and unsecured, meaning that collateral in the form of assets may be necessary, and most lenders require good credit and a strong business history, often of at least six months to two years.
Business Credit Cards
If you’re a new business, remember that a business credit card functions very similarly to a line of credit and can be used for some, but not all, expenses that require working capital. Business credit cards are more available to newer companies and those with lower credit scores, and so they should be kept in mind as an option if your company doesn’t qualify for a line of credit.
The United States Small Business Administration (SBA) guarantees many loans to small business owners. They work with financial institutions to provide a guarantee of up to 90% of the principal of many small business loans. That means lenders are protected from losing significant money if a borrower is unable to make payments and defaults.
There are three main types of SBA loans: 7(a), 504, and microloans. Two are particularly helpful for working capital financing. SBA 7(a) loans have repayment terms of 10 years for working capital loans, and are the SBA’s most common lending option. They can be as large as $5 million, and have very stringent requirements for borrowers.
SBA microloans are also fantastic options. The SBA works with locally-based nonprofit lenders to offer financing of up to $50,000 which can be used for working capital infusions. If you’re eligible and have good credit, these options are often the most affordable, though they also involve a lengthy application process.
If you’ve got customers who haven’t yet paid their invoices, invoice financing can be a low-cost option for short-term capital infusion. In invoice financing, the lender advances the borrower a portion of all outstanding invoices. You’ll typically receive a significant portion of the advance up front and receive the remainder once the invoices have been paid. The lender makes money by charging a fee (typically a percentage of the total advance) and also charging money for delays in payment.
Invoice factoring is a similar process, in which a lender effectively purchases outstanding invoices. However, in invoice factoring, the customers then pay the lender directly. It’s another helpful option for receiving a helpful cash deposit.
Merchant Cash Advance
A merchant cash advance works by selling a portion of future debit and credit card sales in exchange for a lump sum. Merchant cash advances are not loans, and you won’t pay interest. Instead, lenders are paid via a factor rate, which is a number typically between 1 and 2. If you are advanced $10,000 at a factor rate of 1.25, you’ll repay 10,000 multiplied by 1.25, or $12,500.
Merchant cash advances typically work very fast – you may see the advance hit the company’s bank account in a day or two. They’re also able to be repaid depending on the rate of transactions within your company. If you’re doing a lot of business, you’ll make more and larger payments, since the payments are based on credit and debit card transactions. In slower times, payments will be smaller, lessening cash flow issues.
Mistakes to Avoid
Working capital financing is a powerful tool for growth, but there are a few pitfalls you’ll want to avoid.
Borrowing too much or too little
If you seek too large a loan amount, your working capital financing can hamper your financial health in the future. Remember, most working capital financing exists to help your business grow and expand. If you saddle yourself with a significant loan and don’t grow, you might be looking at disastrous monthly payments in the future.
On the other hand, if you don’t borrow enough money to fuel growth, you’re also setting yourself up for financial issues. Even a reasonable monthly payment can be a hindrance if the debt doesn’t lead to additional revenue.
Have a realistic idea of what growth will look like and how additional debt fits into your business plan.
Looking for the wrong financing
Working capital financing needs to be used as working capital. If you’re looking to buy a vehicle or a piece of equipment, there are financing options available for those specific purposes. Working capital loans tend to be shorter-term and thus a bit pricier. They may be unsecured. So if you’re looking to make a real estate purchase or to acquire some other long-term asset, it might be smart to check out a different form of funding better suited for that purpose.
Being unprepared for application
Finally, make sure that you’ve got your house in order when it’s time to put pen to paper. Gather all necessary documents – your balance sheets, your credit history, your tax returns. Have you used proper accounting software and completed all necessary work on your books? Are there documents you may need but haven’t consulted in years? Make sure that you’ve got accurate, up-to-date copies of all necessary financial documents and that your company is fully qualified for the working capital loan you’re looking for.