Working Capital Loans for Small Businesses

Simply put, working capital is the amount of  money your business has on hand to cover day-to-day operating expenses and is essential for, well, keeping your business working. Whether you own a bakery, barbershop, or fitness studio, you require a certain amount of cash on hand to keep your operation afloat–that’s your working capital.

If you’re struggling month-to-month to pay your bills or don’t want to put a dent in your existing cash reserves to finance a growth opportunity, a working capital loan may be right for you. Here’s what you need to know.

What is working capital?

Working capital is the amount of cash a business has on hand to cover day-to-day business expenses: payroll, electricity bills, supplies, and rent, to name just a few. If you want to increase your cash flow and don’t want to take on a long-term debt obligation, a working loan could be a good fit for you. 

Working capital formula

Your working capital can be calculated using the following formula (with the information available on your balance sheet):

Working Capital = Current Assets – Current Liabilities

• Current assets (what you own) = Cash and cash equivalents, as well as any assets (e.g. inventory) that can be converted into cash within one one year
• Current liabilities (what you owe) = Any debts or other obligations that must be paid within one year

Let’s take a look at a sample balance sheet as an example:

If your business has $300,000 in current assets and $150,000 in current liabilities, your working capital would be $150,000. However, looking at only a dollar amount isn’t necessarily a good way to take measure of a company and its financial health.

That’s where the working capital ratio comes into play (also known as “current ratio”). The following formula is used to calculate your working capital ratio:

Working capital ratio

That’s where the working capital ratio comes into play (also known as “current ratio”):

Working Capital Ratio =  Current Assets / Current Liabilities

Using the same example from above:

Working Capital Ratio = $300,000 / $150,000 = 2

A working capital ratio lower than 1 means your company has negative working capital, whereas a working capital ratio between 1.2 and 2 means your company has positive working capital.

Calculating your working capital ratio is helpful because it offers some quick insight into your financial standing and helps you understand how well positioned you are to cover short term expenses.

For example, your business and available working capital may be growing year-over-year, but if your liabilities are increasing at a similar rate, this could signify some upcoming liquidity issues. The working capital ratio gives you a more holistic understanding of the financial status of your business, especially when analyzed on an annual basis.

If your working capital ratio is trending toward stagnant or decreasing, it may indicate that it’s time to tighten your operations and explore your financing options.

Do I need working capital?

Healthy cash flow is vital for all businesses, but it becomes especially important when you’re trying to expand  and grow. As the saying goes, “It takes money to make money.” Even if your current capital can keep your business out of the red in its current operating state, you may need an injection of capital if you are planning to increase production or scale-up your operation in another way.

Whether you find yourself with a tight operating margin or simply have an opportunity that you can’t afford to turn down, a working capital loan could be the right financing solution for your business.  

“We just needed flexibility. The money will get paid back on the sales we do. But we need the money to pay for things upfront, because everything we do is paid for upfront. Before we even get product we pay for it.”

How much small business working capital do I need?

Determining the right amount of capital to borrow can be tricky. Borrow too much, and you could be in over your head with debt; borrow too little, and you may end up with a half-baked vision, unable to hit your break-even point.

One strategy to help you determine the right amount to borrow is to try thinking like a lender and consider your “capacity.” Capacity, in this context, is your business’ ability to repay the loan. What do your cash flow projections look like? How will the money you borrow contribute to the trajectory of your business? How much money do you need to get the job done?

For example, if you’re considering expanding your fitness studio to a second location, it’s so important to make sure you are accounting for the full spectrum of expenses. It’s probably not enough to only consider the upfront, obvious costs like renovations, purchasing equipment, and the first few months of rent; you’ll also need to take into account other fixed and variable expenses like utilities, hiring instructors and other , cleaning costs, insurance, licensing fees, advertising and marketing, supplies, and payroll. Do you need a real estate broker to show you locations or a lawyer to review your lease? Did you take into account seasonal ebbs and flows in business (New Year’s resolutions, anyone)?

Working through these questions and calculations and making sure you have a realistic sense of expenses will give you a better idea of exactly how much money you need to take the financial pressure off your business to either sustain operations or pursue growth. 

Working capital business loans: common use cases

A business loan can do wonders for your cash flow, freeing up capital that otherwise would not be available. You can use the funds for almost any business purpose. This includes taking advantage of new opportunities and covering unexpected expenses. Here are a handful of common use-cases:

• Expand your footprint: Whether you’re looking to increase the size of your office or open an additional location for your store, a working capital loan can help you cover the myriad of cost associated with expansion. 
• Refinance debt: If you have multiple small business loans on your books, refinancing them into a single loan could help you streamline your monthly payments, making it easier to manage cash flow. You also may be able to get a lower interest rate on a working capital loan compared to what you were paying across multiple loans.
• Buy inventory or equipment: Essential equipment is necessary to run a successful business, but more often than not, it comes with a high price tag. Inventory is equally necessary to a business, but insufficient capital can restrict your ability to purchase inventory in bulk. A working capital loan allows you to repair or replace equipment for your business as needed and purchase inventory as a scale that allows your to meet customer demand.
• Expand your team: Oftentimes, your business is only as strong as the team you’ve built. A working capital loan gives you the opportunity to hire talented new employees. 
• Meet seasonal demand: Many small businesses operate on a seasonal schedule where the ability to hit sales forecasts in a period of months, or even weeks, can determine the outlook for the entire year. A working capital loan can help you hire additional seasonal staff, increase marketing efforts, or bulk up inventory. 
• Marketing: Marketing is an essential part of running a business, but reaching new prospective customers often comes at a cost. A working capital loan can help bolster your marketing efforts by allowing you to invest in digital advertising, local print ads, or through strategic partnerships. 

How do I prepare for a small business working capital loan?

As a general rule of thumb, you can never be too prepared when it comes to applying for a small business loan. If you have your books in order and the necessary documents compiled when you first meet with a lender, it sends a great signal and allows you to move much faster. Here are some tips to get you started:

• Know your business: It’s important to be able to articulate the market opportunity as well as how you will be putting that $50,000, $100,000, or even $500,000 to work. With research under your belt and a clear vision in mind, this process will set you up for success.
• Get your personal and business credit in order: While your credit score isn’t always the end-all-be-all of a loan application, it does speak to your financial responsibility as a borrower. It also can affect the terms of your offer — generally, the higher your score, the more likely it is you’ll be able to access higher loan amounts at more favorable terms. Always review your personal and business credit reports and scores before applying for a loan and make sure you don’t see any errors or inaccuracies. If your credit rating isn’t quite where you want it to be put, start honing in on how you can improve it.
• Compile your documents: Required documentation varies from lender to lender, but many will ask for your financial statements, tax returns, and current bank statements for both you and your business. Do the legwork and have these items on hand prior to beginning the application process.
• Check collateral requirements: Working capital loans can be secured or unsecured, meaning you may or may not need collateral to qualify. Before you get too far along in the application process, check to see if the lender requires collateral for a business term loan and if so, what type of collateral is needed. Keep in mind that even if a loan is unsecured and no collateral is needed, a personal guarantee may still be required. This guarantee makes you personally liable for the loan if your business defaults on the payments.

What should I consider when applying?

Working capital loans come in many different forms: term loans, lines of credit, invoice financing, SBA loans, and merchant cash advances (MCAs). It’s crucial to choose the right type of financing (and lender) to help you meet your goals. With this in mind, here are a few things that you should consider when researching small business loans:

• Speed of application process. As a business owner, you likely don’t have weeks to wait around for a decision about a loan. The underwriting process at traditional financial institutions can be lengthy, confusing, and opaque. And while the SBA offers some of the most affordable rates around, it takes a long time — it’s recommended you apply at least six months prior to actually needing the funds in your bank account, which doesn’t do much in the way of flexibility or speed. Some online lenders guarantee speed, but the quick turnaround can come at the expense of a higher APR. At Funding Circle, we have a 6-minute application that allows us to learn about your business and present you with all of the loan options available to you from a variety of lenders—all in one place. 
• Repayment terms. A working capital loan should improve your cash flow, not cripple it. It is important to understand the terms and conditions of any working capital loan prior to committing. For example, merchant cash advances are structured so you pay the loan back with a percentage of your daily credit card sales, usually over just a few months. While this pay-more-when-you-make-more model might work great for some companies, it can also affect your bottom line if you are unprepared. And with credit cards, unless you can pay off the balance in full at the end of the billing cycle, you may find yourself in a downward debt spiral. Term loans allow you to make recurring payments on a monthly basis, but they sometimes come with prepayment penalties.
• Interest rates. A high-interest rate isn’t conducive to growing a business. Understanding the annual percentage rate (APR) is key when it comes time for you to evaluate your working capital options. APR represents the true cost of your loan because unlike the interest rate, APR also takes into account additional fees and charges. Depending on your working capital needs, you may find one option to be more favorable to meet your goals. However, before you sign any papers, you should understand all of the terms and conditions associated with your loan.

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