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Understanding Working Capital Loan Requirements
Working capital is the backbone of your business. It’s the money your company uses to handle daily business activities and operational expenditures. Everything from the money required to run equipment to your employees’ salaries come from your working capital.
As such, a lack of working capital creates cash flow issues inside a business. Thankfully, there are several types of working capital funding you can use to relieve the situation. These funding options fall under the umbrella of working capital loans:
- Short-Term Business Loans
- Lines of Credit
- Accounts Receivables Loans
- Small Business Administration (SBA) Loans
Before applying for a working capital loan, you need to understand the loan qualification requirements your business must meet.
What are your requirements for a working capital loan?
First and foremost, you must figure out your needs from a working capital loan.. Ask yourself these questions if you’re unsure whether you should apply.
What’s the loan amount you need?
To determine the working capital loan amount your business needs, you must calculate the working capital ratio.
Working Capital Ratio = Current Assets/ Current Liabilities
If the value of working capital ratio falls between 1.5 and 2, you have sufficient cash flow to keep your business running smoothly. But if this ratio falls below 1.5, it indicates the shortage of working capital. You can determine the loan amount by calculating how much “Current Assets” do you need to keep the ratio between 1.5 and 2.
How do you want to access the funds?
There are two ways a lender may disburse working capital funding:
- Lump Sum – A one-time transfer of all of the funds for which you apply.
- Revolving Line of Credit – You get a line of credit you can use as and when you need it.
Ask yourself which of these options best suits your business. A lump sum may be best for temporary cash flow issues, while a line of credit may be better for frequent financial crunches.
What repayment terms can you afford?
Every working capital loan comes with an interest rate and payment period. Both can affect your decision to opt for the loan. For example, many working capital loans allow you to make weekly, bi-weekly, or monthly repayments. Monthly repayments are larger, but also less frequent. Weekly payments are more regular, though your business may find them more manageable. The interest rate attached to the loan affects how much you repay.
Repayments work differently with merchant cash advances (MCA) and accounts receivable loans. You repay MCA loans via your daily or weekly credit card transactions. With accounts receivable loans, your invoices serve as collateral. Once your customers pay their invoices, you repay your loan with that money, with an additional fee.
Are you willing to offer collateral to the loan?
Collateral is an asset or item of value you pledge as security on a loan. If you default on your repayments, your lender collects the collateral item to cover their costs.
Many traditional lenders require collateral before you can access their working capital loans. Ask yourself if you’re willing to offer this collateral and, more importantly, if you’re willing to lose the asset itself.
What are lender requirements to qualify for working capital loans?
As mentioned, working capital loan qualification requirements vary from lender to lender. However, most have some common criteria you must meet to access a loan. Here are some factors that lenders look into while approving working capital funding.
Personal & Business Credit Scores
Both personal and business credit scores can impact your loan qualification chances. Your lender will likely check both scores with the major U.S. credit bureaus, including Experian, TransUnion, and Equifax.
Both your business and personal credit score incorporate information about your available credit, tax judgments, and payment history. Lenders use it to determine how reliable your business is with money.
Age of the Business
Lenders look for stability when determining how much you can borrow. The shorter your company’s established history, the less amount the lender will offer. Therefore, start-ups may find it difficult to obtain working capital funding. Conversely, older businesses often find it easier to access financing of working capital.
Most lenders look for your business to have a trading history of at least six months before offering these loans.
Annual Revenue & Profits
Lenders check your annual revenue to see how much profit your company makes. If the loan amount you apply for exceeds this profit figure, you’re less likely to get the loan. Again, this comes down to stability. The lender wants to see that your company earns enough to make repayments.
Debt-to-Income Ratio
Your debt-to-income (DTI) ratio is a measure of your personal credit history. It allows a lender to weigh your existing debt payments against your monthly income using the following formula:
DTI = Monthly Debt Payments / Gross Monthly Income
For example, imagining you have an income of $5,000 and debt repayments of $2,000. The equation produces the following result:
2000 / 5000 = 0.4
So, your DTI is 40%.
Lenders want to see as low a percentage as possible.
Debt Service Coverage Ratio
Lenders use your debt service coverage ratio (DSCR) to measure if your company’s current cash flow services its debt obligations. Similar to DTI, it’s a measure of debt-handling capacity. Lenders use the following formula for DSCR:
DSCR = Net Operating Income / Total Debt Service
If your business’ operating income is $500,000 and debts of $200,000, you get the following result:
500,000 / 200,000 = 2.5
DSCRs closer to 1, or below 1, tell the lender you’d struggle to repay a loan for working capital.
Collaterals or Personal Guarantee
Offering either collateral or personal guarantee gives you access to higher loan amounts, as well as lower interest rates. Collateral-based loans are also an option for those with low credit scores. The downside is that you assume a high risk if you default. Plus, loan applications are often more complicated when collateral is involved.
A lender may ask for collateral if you have a poor credit history. They may also require it for businesses that have low DSCRs.
Business Plan
Your business growth plan is your company’s roadmap for the future. It tells the lender what you do, how you make money, and what your projections are for the future. Lenders often check business plans to learn the following information:
- Who you serve
- How you generate revenue
- What your market looks like
- Who’s in your management team
- Your financial projections
- The collateral you can offer
Bank Statements, Income Tax Returns & Other Documents
Most lenders require financial documentation when you apply for a loan. These documents include income tax returns and bank statements. Think of these documents as a track record of your company’s financial history. Your lender may ask for these documents from all major shareholders.
Beyond these two documents, a lender may also request the following:
- Proof of collateral
- Debt declarations
- Proof of business ownership
- Employee identification numbers (EINs)
Frequently Asked Questions
Working capital loan vs. line of credit – which is better?
Both options offer short-term solutions to cash flow problems. A line of credit may suit companies that require a consistent pool of funds to dip into when needed. However, working capital loans tend to come with locked interest rates and can offer lump-sum funding.
How is the working capital loan amount determined?
Lenders examine several things to determine how much you can borrow with working capital funding. In addition to looking at your company’s finances, they may check your shareholders’ finances. They’ll also look into what your business does and how much revenue it generates.
