Is a Working Capital Loan Right for Your Business?
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Are you struggling to pay rent on time, or worried about making payroll? It’s common for many small business owners to face difficulties meeting daily expenses. The uncertainty of cash flows makes it hard to align cash receipts with due dates, but paying some bills late could have serious consequences.
When the timing of cash flows interferes in the orderly running of your business, taking out a loan could smooth over any bumps. A working capital loan gives you the cash to meet daily obligations while waiting for customers to pay invoices, but it can have some drawbacks. Here’s how to determine if a working capital loan is right for your business.
What is Working Capital?
Working capital is the funds you need for the day-to-day running of your business. These expenses include rent, payroll, and utilities. It’s the money needed if the business continues at its current level, and does not include funds to expand.
To calculate working capital, subtract current liabilities from current assets on the balance sheet. A positive number indicates that you can fund current operations and possibly expand. A negative number could mean future difficulties with liquidity and poor short-term financial health.
The working capital ratio is current assets divided by current liabilities, and represents your company’s ability to cover its current obligations if everything came due at once. Industry standards for a “good” ratio vary, but generally speaking a ratio of 2:1 (so two times the assets available to cover the liabilities) is healthy.
What is a Working Capital Loan?
A working capital loan is a short-term loan for business owners struggling to meet working capital obligations. The loan requires less documentation than a traditional loan can fund quickly – sometimes in as few as 24 hours – which makes it a great choice to solve an unexpected cash flow issue.
Working capital loans have higher interest rates than other loan products, and you could pay 9% to 45% for the loan. This is in part because they fund so quickly, and a shorter repayment term. The interest rate and shorter repayment term leads to a higher payment than other loan products. When you owe more over a shorter period of time, your repayment amount will be more.
Their cost and short-term nature makes them ideal in a pinch, but not the best loan product for larger and long-term projects. There are five signs that a working capital loan is right for your business.
Five Signs a Working Capital is Loan Right for your Business
Do these situations apply to your business? Then a working capital loan is right for you.
One – It Solves Cash Flow Issues Quickly
Applying for a short-term business loan at a bank can take months – both to gather the necessary documentation and to wait for approval. If you need cash quickly, look to working capital loans from alternative lenders. These loans are meant to meet short-term, emergency needs.
A working capital loan isn’t ideal for larger projects – such as an expansion or investment in a new product. The loan could come due before you complete the project, or not provide enough funds to see it to completion. The cost of the working capital loan could also be greater than the return.
For these funding needs, you have time to plan, budget, and find a short-term or large business loan better suited to your project. Use working capital loans when you need cash in a hurry.
Two – There is a Plan to Repay the Loan
Even an expert financial planner can’t predict the behavior of others. If your cash flow issues arose because a customer paid late, or bounced a check, you couldn’t have predicted the need to borrow. But you can likely predict when you’ll receive the payment or can cash the check.
Whenever you borrow, make sure you have a plan to repay the loan. Put the estimated payments in your budget and stick to the repayment schedule. The loan should help with cash flow problems, not make them worse. When the money does come in, pay off the loan.
Three – The Loan Supports Long-Term Goals
What if you have the cash to meet working capital expenses, but it’s ear-marked for something else? If you’ve been setting aside money to invest in a new machine, a new product line, or fund another business growth plan, you could use that money to meet working capital needs. But a working capital loan could help keep you on track to meet larger business goals.
Taking out a working capital loan to solve a temporary cash flow issue keeps your business on its desired growth path. If you can avoid touching funds set aside for another purpose a short-term problem won’t derail long-term plans.
Four – It Avoids Pledging Collateral
Many lenders require that you pledge collateral to secure a loan. This could be a commercial oven to secure an equipment financing loan for a bakery, or a business’ investment accounts or other assets. The risk to pledging collateral is that, if you default on the loan, the lender could seize the collateral.
Even if you have collateral to pledge, you might not want to take the risk. Losing a key piece of equipment, for example, could put your company out of business. Working capital lenders typically don’t require collateral for their loans.
Five – You Have Bad Credit
If you have a credit score less than 700, you have likely discovered that traditional lenders are reluctant to work with you. Borrowers with bad credit may have to pledge more collateral or personal assets to secure funding. But working capital lenders care less about your credit score and more about your business’ cash flows.
If your business generates minimum monthly revenues of $10,000 but you have a credit score as low as 650, you can still take out a working capital loan.
Downsides of Working Capital Loans
Did you check off all the boxes on the above list, and are you sure a working capital loan is right for your business? There are pros and cons to any lending product, so before you apply for a working capital loan make sure you understand how its downsides will impact your business.
High interest rates and large payments can hurt cash flow
The interest rates on a working capital loan are not the cheapest available to borrowers. You’re paying for speed and convenience. As well, since the loans typically have repayment terms of less than a year your monthly payment amount will be higher.
For example, a $10,000 loan repaid over two years would lead to a monthly payment of roughly $416. But if you took out a $10,00 loan and repaid it over six months, your payment would be $1,666. The repayment period can have a significant impact upon the payment amount.
Since the purpose of a working capital loan is to solve cash flow issues, it’s counterintuitive to take one out if it would worsen them in the long run.
The lender could require collateral or enforce prepayment penalties
Read the fine print carefully.
Some lenders do require borrowers to sign a personal guarantee, giving the lender the right to pursue your personal assets if you default. Others could ask you to pledge business assets. If you’re not comfortable with this, find a working capital lender willing to extend unsecured credit.
As well, some working capital lenders put prepayment penalties in their contracts. This protects their profit, but it means there’s no benefit to you for paying off the loan early. You would have to pay the fee – often the interest they would have made over the loan’s full term – regardless.
It could hurt your credit
A working capital loan will go on your credit report. If you make late payments or default, it will hurt your score. Increasing the amount of debt you carry, and your debt utilization ratio, can also impact your score negatively.
A lower score could make it harder to borrow or receive favorable terms in the future. With a lower credit score, you’ll pay higher interest rates because you represent more risk to lenders.
Is a Working Capital Loan Right for You?
By now, you probably have a good idea if a working capital loan is right for your business. You’ve weighed its downsides against your business needs and know the impact the loan will have on your business. If it’s time to explore your business loan options, reach out to be connected with a lending specialist at Shield Funding today.