A working capital loan is a business loan used to cover everyday operational expenses. Businesses may use these loans to expand their inventory, invest in production equipment, or for other short-term operational expenses. To understand working capital loans, you’ll need to understand what working capital is and how it works.
Working capital, also known as net working capital, refers to the amount of funding owned by a business that is currently available and may be used for production or other operating activities. It is calculated by deducting the business’s current liabilities from the current assets. Businesses aim to maintain their working capital to cover debts and potential financial issues, and to invest back into their business to potentially increase their profit.
Understanding how working capital impacts your business can help you to make better financial decisions and help you determine whether a working capital loan is right for your business. Learning how working capital loans work, as well as how to apply for these loans, is important so you know what to expect.
Key Takeaways
- A working capital loan is used by a business for daily operations expenses that are short term, such as raw materials and inventory.
- Working capital refers to the funds owned by a business that are readily available to purchase short-term operational expenses.
- Working capital can be calculated by subtracting current liabilities from current assets.
What Is a Working Capital Loan?
A working capital loan is a type of business loan used for expenses relating to the business’s daily operations, such as rent, insurance, payroll, and utilities. The loan can also help cover expenses such as raw materials and inventory, as well as for other costs incurred for daily operations.
Working capital can be calculated using the balance sheet, which is a statement that shows a business’s value by recording all assets and liabilities.
Note
The total working capital is determined by subtracting current liabilities from current assets.
Working capital is important in terms of how the business is perceived financially as the amount shows a business’s ability to pay for operational activities. Businesses need to maintain more working capital to potentially increase their profit. A higher amount of working capital also increases a business’s overall value as working capital is considered a capital asset.
When Working Capital Loans Work Best
Working capital loans are beneficial for businesses looking to expand but they must also be able to afford to take on this extra debt. These loans will incur fees and interest, which, in the long run, become an added expense. Businesses without the cash flow to take on a loan should wait until they improve their cash flow. Business owners should forecast their sales or create a cash flow projection before deciding whether they’ll be able to repay the loan.
How Do You Apply for a Working Capital Loan?
The application process for working capital loans is similar to the process for applying for business loans in general. Business owners can take a few steps to ensure they begin the application process in the right direction.
Develop a Business Plan
A business plan outlines the purpose of your business and explains how you plan to operate and finance your business. It’s not only important for potential investors to understand your objectives, but it can help provide insight about your business to banks and other lenders. With a business plan, you can showcase how your cash flow is generated to prove you can make timely payments on your loan.
Determine Your Personal and Business Credit
For small business owners who already have credit established for their business, banks and credit unions can simply use the information associated with the business’s credit to decide on a loan approval. For small business owners and entrepreneurs who run their businesses as sole proprietors, personal credit will likely have an impact on getting a loan. Therefore, it’s important to monitor your personal credit report as well as your credit score so you know where you stand.
Note
Monitor your credit utilization and if possible, keep it below 30%. The amount of debt owed impacts your credit score as it accounts for 30% of your overall FICO score. By using less than 30% of your available credit, you could increase your credit score.
Conduct Research and Compare Lenders
Conducting research is crucial if you want a lower interest rate or any other specific terms. Being informed about the different types of loans that are available for your business can help you to make a better decision. You can consider if your business could benefit more from a line of credit compared to a regular business loan. The loan you choose depends on your business needs. For example, you may find you qualify for a lower rate on Small Business Administration loans, but the application process is much longer when compared to a loan from a bank.
Collect Business Documents
Lenders may need more than just a business plan and credit score to approve a business loan—especially if the latter doesn’t meet the minimum qualifications. Additional documentation a lender may request includes:
- Personal and business tax returns
- Business bank statements
- Business financial statements
- Documents showing any business debts
Types of Working Capital Loans
A working capital loan can come in several different forms. Although the different types have the same purpose, they each have their pros and cons. The type of working capital loan you choose depends on the needs of your business and your preference on the terms and availability of funds.
Line of Credit
A line of credit provides access to capital for businesses with short-term financial needs. A revolving line of credit works just like a credit card and can be beneficial to businesses looking for additional funds at their convenience. As it is paid off, you can continue to use the funds as needed.
Alternative Lending
Alternative lending includes many different forms of financing. It is an alternate to the traditional loans offered by banks. Alternative lending is an option for those businesses that don’t qualify for a regular loan or prefer the services offered by alternative lenders.
Note
Although alternative lenders may have higher interest rates, many have streamlined their application and approval process to make it simpler and quicker to secure funds.
Invoice Financing
Another method business owners can opt for to improve their cash flow is invoice financing. Invoice financing, also referred to as accounts receivable financing, allows businesses to receive a cash advance for unpaid invoices. Businesses can receive the funds quickly, sometimes within two days. The invoice finance provider can give cash advances that amount up to 90% of the amount on the original invoice.
Term Loans
Term loans are business loans that offer fixed monthly rates. This is ideal for businesses that need larger amounts of funding. Term loans are available through banks, credit unions, and online resources.
Working Capital Loan Rates and Fees
The rates and fees associated with a working capital loan can vary depending on how much money you’re borrowing; the type of loan you’re applying for; the type of business you run; your credit score rating; whether collateral is considered; and other terms set forth by the bank or credit union.
Note
To qualify for a lower interest rate, start considering your options well before you decide to apply for a loan. Take the time to work toward improving your credit score, comparing terms from different lenders, and considering shorter-term loans.
Frequently Asked Questions
Where does a working capital loan go on the balance sheet?
A working capital loan is recorded in the liabilities section of the balance sheet, specifically in the noncurrent liabilities section. In general, loans are classified as noncurrent liabilities because the interest and other fees are not due within the specified time period.
What’s the difference between a working capital loan and a line of credit?
A line of credit is different from a working capital loan when it comes to when and how the funds can be accessed. A line of credit is available to use whenever it’s needed, but loans are limited to the fixed terms concerning monthly payments and other terms.
Why would a business be declined for a working capital loan?
A business may be declined for a working capital loan for a number of reasons. If a business does not meet the qualifications set by the bank or if the application is incomplete, it may be declined. Some of the qualifications where businesses could fall short may include a particular credit score, a certain amount of cash flow, or other factors regarding how established your business is.
