What is a working capital loan and how does it work?
Key takeaways
- Working capital loans are a type of short-term business loan designed to help businesses cover their regular operating expenses.
- Working capital is calculated by subtracting current liabilities from current assets.
- There are many types of working capital loans, including term loans, lines of credit, business credit cards, invoice financing, merchant cash advances and SBA loans.
As a business owner, there are seasons of low revenue or other factors that can temporarily reduce working capital and place your business in financial hardship. Cash flow is the number one problem small businesses face, according to the U.S. Chamber of Commerce.
A working capital loan could be the answer to your working capital shortfall. Understanding what these loans are and how they work will help you ensure a temporary and affordable solution to a temporary problem.
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 like:
- Payroll and wages
- Employee benefits
- Rent or lease payments
- Utilities
- Supplies
- Insurance
- Short-term debts
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. Consider all your loan options to choose the best loan for your business, such as term loans or 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. 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 of between 1.2 and 2.
Pros and cons of working capital loan
Pros
- Quick funding
- No specific collateral required
- Eligibility requirements are more lax than standard business loans
- Funds can be used for any expenses
Cons
- Higher interest rate than a conventional loan
- Shorter, more aggressive repayment
- Loan amounts are often low
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.
Sometimes, 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.
You’ll need good-to-excellent credit to see the lowest interest rates on working capital loans. But if you don’t have time to build credit, there are working capital loans for bad credit. Some lenders are willing to work with business owners with credit scores as low as 500.
Types of working capital loans
There are many types of working capital loans, each with different features and designed for different situations.
| Types of working capital loans | Description | Key details |
|---|---|---|
| Term loans | Traditional loans that offer lump sums upfront with a regular repayment schedule. | Paid out in a lump sum Fixed payments Longer repayment terms available |
| SBA loans | Government-backed loans with large limits designed for businesses that can’t qualify for conventional loans | Large loan limits, upward of $5 million Competitive interest rates capped by the SBA Slow approval and funding |
| Business lines of credit | Draw funds multiple times as needed and only pay interest on your balance. | Flexible access to cash Credit limit can be used again as you pay back loans May have withdrawal or maintenance fees |
| Business credit cards | Use for everyday purchases up to the credit limit and only pay interest on the amount borrowed. | Helps build business credit Low maximum rates No interest if paid in full |
| Invoice financing/factoring | Loans secured by the value of your invoices. Get a percentage of the amount you’re owed without waiting for payment. | Borrowing limit dependent on your invoiced amounts Lose a percentage of what you’re owed Automatic repayment when invoice is paid |
| Merchant cash advances | Offers you an advance on future sales and automatically repaid through a percentage of your daily or weekly sales | Cover emergencies and cash shortfalls Automatic repayment High rates and fees |
There are trade-offs between secured and unsecured working capital loans. Secured loans have a lower risk for the lender and a higher risk for the borrowing business. But, they offer a lower interest rate and higher loan limits. A secured loan may be your best route if loan size and rate are paramount. But if you need fast cash and don’t want to risk your assets, go the unsecured route.
Where to get a working capital loan
Many different lenders offer working capital loans, including banks, credit unions and online lenders. 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. They also tend to have strict criteria to be eligible for a business loan, such as having a personal credit score of 670 or higher.
Online lenders
Online lenders are typically nonbank companies that operate solely on the internet. They offer various types of loans and financing, including alternative financing like invoice factoring and merchant cash advances. You apply for and complete the business loan application online, streamlining the process without having to go in person to a bank.
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. But that speed and flexibility come at a cost, with the lender requiring high rates and fees unless you have strong credit.
SBA loans
SBA loans are loans guaranteed by the U.S. Small Business Administration and offered through approved SBA lenders. These loans offer large loan amounts and capped interest rates and are designed to help business owners who can’t qualify for traditional financing.
However, SBA loans involve a lot of paperwork and require SBA approval. Because the approval process is more involved, funding can take 30 to 90 days to get approved and reach your bank account.
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 that different lenders offer to get the best deal.
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