Pros and Cons of Working Capital Loans
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Short on rent money for the month for your business? Worried about making payroll next Friday? Your financial advisor or banker may have suggested a working capital loan.
Small business owners often utilize a variety of loan products to meet capital needs, each meant for a different purpose. A working capital loan is a short term solution to cash flow problems that can be used to finance a business’ daily operations. When used wisely, these types of business loans can smooth over the bumps in a business’ road, but before you apply for one learn about their ins and outs.
What is Working Capital?
Working capital is the money needed to fund your business’ daily operations. Expenses that make up working capital include rent, payroll, and utilities. It doesn’t include special, one-time expenses such as paying for a remodel.
To calculate working capital, subtract current liabilities from current assets. A positive number means that you can pay your bills and have money remaining to cover growth or expansion. A negative number means that if all your current liabilities came due at once, you couldn’t pay them.
If you don’t currently have enough cash on hand to cover working capital needs, you might consider taking out a working capital loan. These short-term loans help businesses with temporary cash flow issues. Like any loan product, however, they have pros and cons.
Pros of a Working Capital Loan
What are the positives to taking out a working capital loan?
Quick and easy cash
Businesses face unexpected emergencies and cash flow issues. Maybe a customer hasn’t paid yet, but rent is due. Working capital loans can fund quickly, and the application process is easy.
A traditional bank loan requires business owners to supply significant documentation during the application process, and can take months to go through underwriting and fund. These loans aren’t well-suited for temporary or emergency needs, but a working capital loan helps out in a pinch.
Solve temporary cash flow issues
It’s simple – you need to pay your bills on time. Failing to make payroll could cost you in more ways than one, both fines but also lost employees.
But sometimes you need a working capital loan for positive reasons. Exponential growth could lead to a need to purchase inventory to meet demand, leaving you strapped when paying daily expenses. Working capital loans can help businesses solve temporary cash flow issues.
Working capital loans don’t require collateral
Another downside to traditional loans is that the lender may ask you to pledge collateral to secure the loan. A commercial oven secures an equipment financing loan, or business investment accounts could be at risk if you pledge them. Anytime you pledge collateral, you risk losing it.
Working capital loans do not require that borrowers pledge collateral. You won’t have to risk a piece of equipment or assets integral to running your business to obtain funding.
There are no restrictions placed on working capital loans
If you take out an equipment financing loan you can only use those funds to purchase a specified piece of equipment. Payroll loans can only cover payroll. But working capital loans don’t come with the same restrictions.
Lenders don’t typically place restrictions on working capital loans. If you’d intended to use the funds to pay rent, but a major customer paid their bill on time and now you want to use them for payroll, you can.
Available to borrowers with poor credit
Most banks won’t work with borrowers who have less than stellar credit. If your personal credit score is below 700, they’re reluctant to lend. But with a working capital loan, as long as your business generates minimum monthly revenues of $10,000 and you have a credit score above 650, you can qualify.
Retain ownership of your business
Taking out a loan is only one way to get capital for your business – another way is to sell equity. But selling equity or taking on a partner can have serious downsides. They could have a different vision for your company and you may find working within their limitations too restrictive.
With a working capital loan, you get the capital you need to run your business but without giving up any equity. You remain in charge.
Cons of Working Capital Loans
There are some drawbacks to working capital loans which you should consider when weighing the pros and cons against your business.
Higher interest rates
Because working capital loans fund quickly, with less underwriting than a traditional loan, and don’t require collateral, the lender takes on more risk. There is more uncertainty about your ability to repay, or pay on time. To compensate for this risk, lenders charge a higher interest rate.
While a traditional bank loan’s interest rate could range from 2.52% to 7%, a working capital lender could charge you 12% and up. These loans will cost you more than other lending products.
The loan must be repaid quickly
Short term, emergency loans also come with a shorter repayment period. Because they’re not meant to fund long-term plans – such as opening a new store or launching a new product line – lenders expect to be repaid quickly. Most working capital loans have a repayment period of a few months.
A shorter repayment period leads to larger monthly repayments because the loan’s total amount is spread over a shorter time. For example, let’s say you owed a lender $30,000. If you repaid that over six months, you’d pay $5,000 a month. But if you repaid it over three months, your monthly payment would be $10,000.
Repayments could hurt cash flows
Once you take out a loan, you have to repay it. If you found yourself in hot water due to cash flow issues, a working capital loan could make them worse. The larger repayment amount will have an impact.
Before applying for a working capital loan plan out your budget and be sure that your projected sales and cash flows will be enough to cover the loan’s repayment.
Could harm your credit
Taking out new debt could drop your credit score. This is particularly true if you already have high credit card balances or multiple loan products open. Even applying for a loan could drop your score five points when the lender checks it during the application process.
A lower credit score will make it more difficult to borrow in the future.
Is a Working Capital Loan Right for You?
While you may be leaning towards borrowing funds to meet working capital needs, it’s a good idea to ask yourself a few more questions.
- Do you have a plan to repay the loan?
Before you borrow, do you have a repayment plan? Have you input the loan’s repayments into your budget and do you know that future cash flows can cover them?
- Is your cash flow problem temporary?
Due to their short-term nature, working capital loans are only temporary fixes. If you need capital to fund larger projects, you might want to consider a large business loan or other loan product. But if you know that cash will be coming in shortly to cover the loan, it’s a safe choice.
- Do you have bad credit?
For small business owners with bad credit, a working capital loan could be your best and easiest way to receive funding. If you already know that your credit score would disqualify you from working with traditional lenders, why waste your time? Approach an alternative lender first.
- Do you need money quickly?
How you intend to use the funds could be less important than meeting an emergency need. If you need money – fast – the short funding timeframe of a working capital loan could make it the right fit for your business. It may be to jump on an opportunity – such as buying inventory at a discount, or acquiring equipment from a competitor who’s going out of business – but as long as the return outweighs the cost of capital, borrowing is a wise decision.
The Verdict on Working Capital Loans
In the right situation, a working capital loan could be a great choice for your business. It’s common for most businesses to need to borrow from time to time. Used wisely, a loan can ensure future success.