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What is Working Capital?

“Working capital” is the cash a company has to fund its short-term operational needs like payroll, rent, and monthly utility bills. What happens when a company doesn’t have the money to cover these regular expenses? Working capital loans are an option that can enable the business to continue functioning in a challenging time when it is short on cash and cannot liquefy assets to cover its operational overhead.

Pros and Cons of Working Capital Loans

Working capital loans can be beneficial for small businesses who are looking to have access to a reserve of funds. The application process is less rigorous than most loans and the amount of time it takes to gain access to the cash after being approved is typically very quick. Lending companies who offer working capital loans don’t typically put parameters around what you can spend the money on. However, lending companies will often ask for collateral to secure the business loan. Working capital loans also come with high interest rates since they typically have shorter terms than other business loans. Since they’re considered short term loans, the payment schedule is often hard for certain small businesses to meet.

How do Working Capital Loans Work?

A working capital loan is a comparatively short-term loan typically used for the purpose of financing a company’s day-to-day operations during a period of reduced business activity. Since they need to be paid off fairly quickly, working capital loans aren’t ideal for long-term business investments like new machinery or an updated computer system. Instead, lending companies design these loans to help small businesses cover every day operational expenses like making payroll or purchasing supplies. However, since all businesses are unique and what they need in order to operate differs, working capital lending companies don’t include many stipulations on what can and cannot be purchased with a working capital loan. Many other types of business loans do have clear restrictions on how the borrower must use the money. This freedom means a simplified application process and more leeway for small business owners in determining how best to apply funding within their businesses.

Working capital loans are most commonly used by businesses that experience seasonality in their revenues. Companies often use these small business loans to get through slow periods with the intention of paying the money back when the lull is over and business is bustling again. Other small businesses might use a working capital loan to stock up on inventory before their busy season or to take advantage of a one-time opportunity.

When Should a Business Take Out a Working Capital Loan?

A working capital loan is ideal for situations when your business is short on capital because of a temporary and identifiable issue. You should see a clear link between spending the money and increasing revenue enough to pay back the business loan within its term.

For example, small businesses like ice cream shops or Christmas tree farms will not have a steady stream of customers throughout the year. In the slow season, a working capital loan can help them continue to operate until business ramps back up. Manufacturers might also make products with a seasonal appeal and need to ramp up production for the peak season during the slowest time. Alternatively, a manufacturer might receive a large order from a new retailer, but not have the money to invest in creating that inventory. A working capital loan would be able to cover the inventory and the manufacturer should be able to pay the loan back in full as soon as the customer paid the business.

Other situations exist where a business might look to working capital loans to help bridge a gap during hard times. For example, a slow economy might lead to multiple clients delaying payment, which impacts the business’s ability to meet payroll on time. A working capital loan can also come in handy for one-of-a-kind business growth opportunities, such as covering the expenses involved with moving to a larger building or purchasing heavily discounted inventory when a competitor goes out of business.

How to Apply for Working Capital Loans

You can very easily begin shopping for a working capital loan online or by visiting a local bank. There are many online lending companies and aggregators that make it simple to comparison shop from the comfort of your home. Before you start, determine exactly how much money you need to borrow and what type of payment schedule is feasible for your business. This will help you narrow down the loan product that is right for you.

After filling out a quick online application with basic business information, your intended lending company will likely request more in-depth documentation as well as a credit check. The required documentation will vary based on the lending company, but it will likely include a legal filing illustrating your ownership of the business (whether a local business license, certificate of incorporation, partnership agreement, or something similar), proof of assets, recent balance sheets, and your latest tax returns. Once those documents are approved, the lending company will present you with a proposed loan agreement. Review it granularly to ensure the conditions are acceptable and the terms practical for your business. If you are not satisfied, continue shopping around. If the loan does meet your needs, you will need to fill out some paperwork to make it final, and it should be funded within a week or so.

A working capital loan can be a great tool to help your business get through a rough patch, take advantage of an unexpected opportunity, or continue operations during a slow season. Research your options carefully to ensure you find a lending company that offers terms that enable your business to grow.

How Much Will a Working Capital Loan Cost?

Since working capital loans have shorter terms than many other financing options, they typically have higher interest rates. Interest rates can vary from around 10 percent to 25 percent depending on the lending company, your credit, and your business history. The longer you’ve been in business and the better your credit score (both personal and business), the better your rate. The amount of valuable assets your business owns (like real estate and vehicles) will also impact your rate. The more assets you can use as collateral, the lower your rate and the more money you can borrow because this means you are a lower risk for the lending company.

Businesses can typically borrow between $5,000 and $500,000 using a working capital loan. Again, the amount your individual business is allowed is dependent on a number of factors on both the lending company’s side and your business’ side. Term length can vary from a few months to a few years. Working capital lending companies can also charge fees for things like processing and early repayment, so be sure to read the fine print before signing any agreement, or you might uncover unexpected expenses down the road.