14 Feb How to Get a Working Capital Loan
Did you know that 82% of businesses fail due to poor cash flow management? In many cases, these failures don’t occur because the businesses aren’t generating revenue. Instead, they happen due to cash flow gaps that form when clients are late with payments or during emergencies.
These issues can reduce working capital, which is the money your company uses to cover its operational expenses. A working capital loan can fill a cash flow gap, allowing you to cover these expenses until cash flow issues are resolved. Here, we’ll explain working capital for businesses and how to get a working capital loan.
Why is working capital important?
Working capital covers a business’s operational costs, such as the expenses related to payroll and inventory. The term also refers to the pool of cash you may dip into when your company encounters difficult times. A lack of working capital means a company can’t cover its day-to-day expenses, which could spell the end of the business.
What is a Working Capital Loan?
A working capital loan is a small business loan that helps you to fund everyday business expenses. Many business owners use the various types of working capital loans to pay for rent and payroll or to cover cash flow gaps that occur during sales slumps. If you’d like to learn more about the pros and cons of working capital loans, check out our blog post.
How To Get A Working Capital Loan Perfect For Your Small Business?
Though there are plenty of types of working capital loans available for small businesses, you need to be careful when choosing your loan. Opting for a financing option that doesn’t suit your company’s needs could lead to you borrowing more than you need or dealing with high interest rates. Luckily, you can find the right types of working capital loans for your business with the help of this guide.
1. Evaluate your working capital needs
You can evaluate how much money you have using the working capital formula:
Working Capital = Current Assets – Current Liabilities
These are calculated for the current year.
You likely have a working capital issue if liabilities pile up to the point where they surpass the value of your current assets. This equation helps you see how much working capital you have, which should be a good indication of how much working capital you need to run your business smoothly.
2. Choose the type of working capital loan that works for you
There are five main types of working capital loans, each with their advantages and drawbacks.
Line of Credit
The lender extends a line of credit you can dip into when needed. You can borrow up to the credit limit and make repayments to regain access to your credit. Flexibility is the main benefit of this working capital loan. However, you may find yourself limited in how much you can borrow via a line of credit.
SBA loans are special loans offered via the Small Business Administration. Loan amounts range from $500,000 to $5.5 million, making them an excellent source if you need a lot of cash. They also have capped interest rates. However, SBA loans have a slow approval process and may often require collateral.
Many alternative lenders offer short-term loans online. You may be able to borrow up to $500,000, with repayment periods of up to three years. Fast application processes and less stringent eligibility criteria are the main benefits of these types of working capital loans.
Merchant Cash Advances
Merchant cash advances allow you to repay your loan using a portion of your credit card or debit sales. While this seems like a cost-effective way to repay, lenders also apply a fee that can make this one of the expensive types of working capital loans.
Accounts Receivable Loans
You use your accounts receivables as collateral for this type of loan. The lender pays up to 80% of the face value of your accounts receivables. The drawback is that you essentially lose the other 20% as a repayment.
3. Know your lending options
You have several lending options when applying for working capital loans:
- Government institutions
- Online lenders/Alternative lenders
- Peer-to-peer lenders
Banks and government institutions have strong track records. However, they also have more stringent requirements and are often slower to accept applications than alternative lenders.
4. Evaluate your credit history
Most lenders require you to have a strong credit score, as well as a track record of on-time repayments of previous loans or credits. Having defaults on your record or having a poor credit-to-debt ratio may lead to a lender rejecting your application. Always check your credit history before spending time applying for a loan.
5. Gather Your Financial Documents
You must furnish several financial documents along with your application. These documents may include evidence of your annual revenue and income tax returns, which lenders use to establish your company’s legitimacy. Gather them in advance of applying to speed up the process.
6. Confirm whether or not you need a collateral
Collateral ties your loan to a specific asset that the lender collects if you default on your loan. This differs from a personal guarantee, which is a promise you make to repay a debt upon which you default using personal assets without specifying what those assets are. Ask your lender if they require collateral or personal guarantee before applying. Be wary of those that do because a loan with collateral places your assets at risk if you can’t make repayments.
7. Apply for a Working Capital Loan
With all of your documents collected, complete your application form and send it along with any other documents that the lender requires. From there, it’s a simple case of waiting for the lender to respond. Note that online lenders tend to have much faster approval processes than banks.
8. Evaluate the interest rates, Repayment, and other terms of the loan
Assuming the lender approves your application, they will inform you of the loan’s terms and conditions. Evaluate them thoroughly. For example, look at the interest rate to determine if it makes the lender’s repayment terms unfeasible. In many cases, you can negotiate with your lender for a lower rate, especially if you have a strong credit history.
Repayment frequency is another critical concern. A loan may become less suitable if you must make payments more frequently than you anticipated. Finally, ask about the loan term. Shorter terms lead to faster repayment, though you’ll pay more per month or week than you would with a loan that has a longer term. Consider which works best for your business when making your decision.
Compare Quotes from Two or More Lenders
Never accept the first quote you receive from a lender. Instead, compare the quotes from several lending options. You may find that a lender that seemed good at first charges a much higher interest rate than an alternative lender.
Choose The Loan and Lender That Best Fit Your Business Needs
After you’ve compared quotes, choose the lender that offers a working capital loan that suits your business and offers appropriate repayment terms.
Frequently Asked Questions
Who is eligible for a working capital loan?
Almost any small business is eligible for a working capital loan. The only exceptions are startups due to them not having the established business track record that many lenders require. Thankfully, startups often have access to grants and other funding options.
How much working capital does your business need?
Ideally, you should achieve a working capital ratio (assets divided by liabilities) between 1.5 and 2.
Working Capital Ratio = Total Current Assets / Total Current Liabilities
If it’s higher than 2, you might be underutilizing funds. Anything lower than 1.5 suggests that it might be time to look into the various types of working capital loans. The lower your ratio, the lower your company’s liquidity. Having a low ratio reduces the amount you can borrow with a working capital loan.
Do commercial banks provide loans for working capital?
Commercial banks do provide loans for working capital. However, these loans come with several drawbacks. For example, commercial banks have much higher rejection rates than alternative lenders, along with much stricter qualification criteria. Some even dictate specifically how you can use their working capital loans.