Working capital is the cash available for your business’s day-to-day expenses. You calculate it as current assets minus current liabilities. Current assets are resources you can turn into cash within twelve months. For example, cash in the bank, amounts customers still owe, and unsold inventory are all current assets.
At the same time, current liabilities are the obligations you must settle within that same twelve months. This includes supplier bills, wages, taxes, rent and loan installments that fall due in the near term.
That said, here’s a quick formula to find how much you currently have as working capital:
Current assets – current liabilities = working capital
Even if a business is profitable, it can still run out of cash when expenses fall before the revenue rolls in. Therefore, working capital loans exist to bridge this gap and ensure you don’t have to scramble for important things.
But a working capital loan doesn’t always fit your situation, so it’s important to know when it works best. This blog explains when working capital loans make sense for small business owners. Read on to ensure you always make responsible decisions.
What is a Working Capital Loan?
A working capital loan is a short-term loan that finances a business’s day-to-day operating expenses. For instance, if you need funds to pay staff salaries, rent, inventory or supplier payments, but there isn’t enough liquid cash, you take a working capital loan.
Notably, lenders base your working capital loan application on your business’s performance, and the metrics used for it include monthly revenue, bank statements, and credit history. After diligence and underwriting, lenders pay out the approved amount as a lump sum to get your business out of the tight spot.
You repay a working capital loan with interest and fees over a fixed term, such as 6-18 months, with weekly or monthly repayments.
Situations Where Working Capital Loans Make Sense for Small Business Owners
Small businesses operate on thin margins in the growing phase and shouldn’t take on new obligations unless they’re crucial. That said, here are some points where working capital loans support small business owners best:
Delayed Customer Payments
Selling on credit is common in B2B, and payment terms can easily be 30, 60, or even 90 days in many industries. This means you deliver the work and invoice the client, but payment can take months. But if your current liabilities, such as rent, wages, or supplier bills, are due soon, a working capital loan can cover them until customers pay. Because you have already earned the money, it will eventually show in your account, so a working capital loan wouldn’t further burden you.
Seasonal Slowdowns
Some businesses earn most of their income in a short window of the year, such as landscapers and tourism operators. Even without year-round income, they still pay rent, insurance, and core staff costs when sales are low.
A short-term loan can bridge that stretch, and the business can repay the debt during the next busy season. But note that your sales history is the best guide to whether this is safe. If last year’s peak comfortably covered the slow months, the pattern is dependable enough to plan around.
Pre-Season Inventory
Inventory is the stock you buy to sell, meaning you pull funds from existing capital to stock up for upcoming sales. If the bank doesn’t have enough $$, a working capital loan can fund that purchase. This financing works best for products with a proven sales record because steady past demand proves the stock will sell. But because unsold stock ties up your cash while loan repayments don’t stop, size the inventory order to cover both the stock and the loan cost.
Upfront Order Costs
If you land a large order, you’ll need extra materials, possibly more labor, and equipment to fulfil it on time; all before getting paid. Needless to say, this can drain your existing funds, and you might still need more to manage the order.
That’s when a working capital loan works because you aren’t committing to an unclear obligation. Instead, you already have a confirmed order in queue and need funds to complete it; what’s better than short-term capital financing at this point?
It’s also very important that you only take this loan if the expected profit on the order will exceed the loan’s total cost. Otherwise, using your business line of credit might make more sense because its repayment terms are generally longer.
Supplier Early-Payment Discounts
Some suppliers offer an early bird discount because it sells their stock fast, especially when they want the stock to sell fast. For example, you might be offered a 2/10 net 30, which means you get 2% off for paying within 10 days instead of paying in a month. While it seems small, skipping that discount can compound, so most businesses try to grab it, even if they have to take a short-term loan. But many short-term working capital loans cost a lot, so check the figures to see if it makes sense.
Conclusion
Working capital financing helps ensure a small business can keep the lights on, even when its account is dry. If you’re also in a situation where managing expenses is difficult, ROK Financial has multiple financing tools that can be tailored for your business. Let’s discuss your current finances and challenges to see which tool will best suit you.
FAQs
Do I need collateral to get a working capital loan?
Not always, because most working capital loans are unsecured and no asset is pledged. However, some lenders still ask for a personal guarantee, especially if you’re borrowing a large amount.
Can I get a working capital loan with bad credit?
Yes, it’s possible in some cases. Some online lenders look at your monthly revenue more than your credit score, so it’s possible to get approved. However, the cost is higher, so compare the total repayment amount before accepting.
Can I repay the loan early?
Sometimes, you can repay earlier than the agreed term. Notably, some lenders allow early repayment with no penalty, but others charge a fee or still collect the full interest. So, check this clause in the agreement before signing.