What is a working capital loan and how does it work?

Every business needs cash that it can use to cover day-to-day operating expenses like wages, inventory purchases and rent. A working capital loan could be the answer if you need to borrow money to cover these costs. But make sure you know the benefits and drawbacks before applying.

What is a working capital loan?

A working capital loan is a short-term business loan intended to help a company make sure it has enough cash to pay for its regular operating expenses. They usually have quick funding and short repayment periods. They’re not designed for larger, more long-term purchases.

While some loans are designed explicitly for working capital loans, some types can be used for working capital or long-term financing. These options include term loans and business lines of credit.

How to calculate working capital

Working capital is the amount of money your company has to deal with its daily operating costs and short-term expenses. To calculate working capital and to see how well you’re able to meet your financial obligations, you subtract your current liabilities from your current assets:

Current assets — current liabilities = working capital

Note that it only looks at current assets and liabilities. Long-term assets and debts aren’t included because working capital is concerned with short-term costs. Positive working capital indicates that you have enough money to pay the bills. Negative working capital is a bad sign in most cases.

You can also use the working capital ratio to measure your liquidity and financial health. To do that, divide your current assets by your current liabilities:

Current assets / current liabilities = working capital ratio

Ratios greater than 1 indicate that you have enough money to pay the bills. Depending on your industry, you may aim for a working capital ratio between 1.2 and 2.

How does a working capital loan work?

Working capital loans work similarly to many other types of loans. Your business can borrow money either as a lump sum or as a line of credit. You then pay that money back — typically over a short period of six months to 24 months.

In some cases, the lender will ask for bimonthly, weekly or even daily payments. There are also unique loan types, like merchant cash advances, that make repayment automatic through a percentage of your sales.

You can consider a working capital loan to help bridge the gap during a seasonal business’s slow months, to take advantage of bulk order discounts from suppliers, to finance a short-term project or to avoid a cash crunch.

Types of working capital loans

There are many working capital loans, each with different features and designed for different situations.

Where to get a working capital loan

Many different lenders offer working capital loans. Banks and credit unions are often the first place people look, but some specialized online lenders offer loans. You might also consider an SBA loan if you need to borrow large amounts. Compare different lenders and their features before you choose a working capital loan.

Banks and credit unions

Banks and credit unions often work with businesses to offer financing. They tend to have lower interest rates and fees than online lenders and can often offer longer repayment terms. But they don’t approve and fund loans as quickly as online lenders.

While bank loans, like term loans or business lines of credit, can be useful for working capital, they may not offer some types of alternative financing, like merchant cash advances or invoice factoring, making them a poor choice if you’re looking for that type of loan.

Here are three of the top working capital lenders on the market.

Online lenders

Online lenders are typically nonbank companies that operate solely on the internet. They offer various types of loans and financing. The application process happens online, so you don’t have to visit a branch or speak to a lender.

These companies often move much faster than banks and credit unions. In some cases, you can get approved for a loan in minutes and see the funds in your account the next day. Many also offer alternative financing, such as invoice factoring. But that speed and flexibility come at a cost. Unless you have stellar credit, you’ll see higher rates and fees. Loan limits are also typically lower.

Consider the following five lenders if you’re looking for an online working capital loan.

SBA loans

The Small Business Administration is a government entity that helps support small businesses across the US. One way it does this is through the SBA loan program. The SBA guarantees loans to businesses, helping them borrow larger amounts with less stringent eligibility requirements.

SBA loans can be great for companies that need a lot of cash, but they often involve a lot of paperwork, meaning they have long approval and funding timelines.

If you’re considering an SBA loan for working capital, you have a few loan types to choose from.

Bottom line

Working capital loans give business owners quick access to cash that they can use for day-to-day expenses. If you’re facing a cash crunch, consider your options and apply for the right loan based on your situation. Before applying, compare the rates and fees different lenders offer to get the best deal.

Frequently asked questions

• How much working capital should you borrow?

  The amount of working capital funding you need depends on your company’s liquidity and financial health. To do that, divide your current assets by your current liabilities. Ratios greater than 1 indicate that you have enough money to pay the bills, but some industries may require a ratio of 2 to ensure all expenses can be paid. Borrowing enough to keep your company in the black can help you maintain financial health.

• Is it hard to get a working capital loan?

  Working capital loans have credit and revenue requirements that may make them prohibitive for new businesses or companies with limited annual revenue. If your business has a credit score under 600 or less than a year in business, you may face higher rates and fees if you’re approved.

• When should a business get a working capital loan?

  Businesses should apply for a working capital loan if they’re facing a cash crunch and may not have the money that they need to pay their bills on hand. They may also be good for time-sensitive opportunities or replenishing inventory.

• Can you get a working capital loan with bad credit?

  Yes, it’s possible to get a working capital loan with bad credit. But the most accessible types of business loans, including invoice financing and merchant cash advances, will have higher interest rates and fees. Be ready to offer collateral or sign a personal guarantee when you apply.