Money used to cover the day-to-day operations of a business is called working capital. Think utility bills, rent, payroll, supplies, and so on. Working capital pays for these daily upkeeps that ensure a business continues to operate. A working capital loan is therefore exactly what it sounds like: money borrowed to cover these costs if and when working capital is low.
It might seem strange at first to think a business would need a loan to cover day-to-day operations, but any business owner knows that income levels vary month to month. Plus, consider any and all potentially missed investment opportunities that could have been funded with what is currently working capital. Also consider investments gone awry.
Consider unexpected expenses, equipment breakdown or repair, unusually slow income, a spike in electricity costs, or even something completely outside of your business that needs financial attention. There are what feels like 1,001 reasons to consider a working capital loan. Before any decisions are made, let us further inform you on the ins and outs.
Furthermore, bear in mind that American Business Credit is beyond well-suited to handle all your needs when it comes to loans of all types. Our focus here is on working capital and the loans therein, but ABC is readily available for any and all loan-based needs.
Working Capital Definition & Formula
You know the basic definition – money used for day-to-day business expenses – but it’s equally if not more important you understand how to calculate working capital. It’s the difference between a business’ total current assets and its total current liabilities. The actual formula looks like this:
Working Capital = Current Assets – Current Liabilities
So, the next step becomes calculating current assets and current liabilities. There are plenty of components that factor into both assets and liabilities, so bear with us. Assets have three main components: cash/cash equivalents, accounts receivable, and inventory.
Cash/cash equivalents include cash, checking accounts, savings accounts, money orders, money market funds, bonds, and several other similar components. Accounts receivable are claims held by a business for payment for goods and/or services. Basically, it’s all the money owed to your business by anyone. Lastly, inventory (in this instance) consists of the monetary value of all goods and materials held by a business with intent to sell.
Liabilities are synonymous with accounts payable. A business’ total current liability is the sum of all money owed to suppliers, vendors, etc. at the time. To calculate working capital down to the dollar, add up all cash/cash equivalents, accounts receivable and inventory, and subtract all current liabilities.
Here’s an example. Let’s say Jim’s Milkshakes has a total of $5,300 in cash/cash equivalents, is owed $975 for an event it recently sponsored, and has a current inventory worth $4,607. However, Jim’s Milkshakes also currently has a total of $7,804 in accounts payable.
($5,300 + $975 + $4,607) – $7,804 = $3,078
Jim’s Milkshakes has a current working capital of just over $3,000 which it turns out is pretty good. But wait. How do we know it’s good? This is determined by the working capital ratio. Instead of subtracting total liabilities from total assets, simply divide total assets by total liabilities. The formula:
Working Capital = Current Assets / Current Liabilities
A working capital ratio between 1.2 and 2 is considered good. The total assets of Jim’s Milkshakes equal $10,882 and the total liabilities equal $7,804 and so the ratio would be just about 1.4 as shown:
10,882 / 7,804 = 1.394413
At this point you should have a firm grasp on what working capital is, how to calculate it, and how to determine the working capital ratio of your business. However, we have so far only shown an example of what is considered a good working capital ratio. Let’s say, God forbid, next month Jim’s Milkshakes has some equipment failure, which causes a drop in profit but a rise in day-to-day costs. Let’s also pretend Jim has forgotten the previous two electric bills. All of a sudden, liabilities go from somewhere around $7,800 to more like $12,800… This creates a negative working capital (-$1,918) and a very poor working capital ratio (0.85). It’s time Jim applies for a working capital loan.
Working Capital Loan Options
You have a vague idea at least of what a working capital loan is. You borrow, you finance your business’ everyday operations with it accordingly, and you pay it back. The loan could cover payroll, rent expenses, or maybe some kind of outlying debt. Here’s what you don’t do with a working capital loan: anything long-term. It’s for the daily stuff. According to Investopedia: “Sometimes a company does not have adequate cash on hand or asset liquidity to cover day-to-day operational expenses and, thus, will secure a [working capital] loan for this purpose.”
Approximately one of every five small businesses fail within their first year. Half fail within five years. This is the sad truth. However, let’s take a look at the opposite logic. An overwhelming 80% of small businesses stay afloat after one year, and still half are doing well after half a decade. Among the many reasons small businesses fall behind is a lack of working capital.
If and when time comes your business needs a shot in the arm in order to cover daily expenses for a while, a working capital loan is the safest answer. American Business Credit provides top-of-the-line and time-tested loans and lines of credit, and serves as an excellent option for a working capital loan. You should know there are five main types of working capital loans.
Bear in mind that working capital loans are meant to cover short-term costs, and therefore usually have short-term payback periods. Most lenders expect repayment with a year. ABC is able to work with any and all business owners seeking a loan. Here are the five main types of working capital loans:
Lines of Credit
If what you seek is constant access to funding with borrowing freedom that allows for customized payback options, a working capital line of credit is your best choice. Be prepared for potentially high interest rates and/or stringent terms and conditions, especially if your business credit score isn’t quite up to par. However, if prepared to pay the loan back accordingly, a working capital line of credit is an excellent option.
Even if as a business owner you don’t find yourself needing immediate cash for working capital costs, a small business line of credit is a potentially viable choice to secure available short-term funding when deemed necessary.
Merchant Cash Advances
When it’s time for cash now in order to cover a daily operational cost, (and you accept credit card payments as a business), a merchant cash advance is a more-than-practical option. As opposed to traditional loan payback, the provider of the advance will take a percentage of your credit card sales until paid back. Beware the percentage rates on such advances, however. They can climb as high as 200%. Additionally, both you and your business may be subject to credit checks upon application.
In terms of smaller-scale businesses, invoice financing involves what is known as factoring. It allows your business to sell its invoices to a finance company and receive immediate payment for what are essentially accounts receivable. Invoice financing is suggested for small business owners who need immediate funding for working capital costs and are also all but guaranteed income based on already-existing invoices.
Small Business Administration Loans [SBA Loans]
Be aware off the bat that qualifying for a reasonably priced SBA loan will indeed require decent credit scores, both personal and business. That being said, if you are confident in your scores, and you don’t necessarily need funding right away, an SBA loan could be a solid choice.
The application process can take up to 60-90 days, but this is with good reason. Upon approval, expect fair interest rates and a lot of flexibility and freedom within loan terms.
Startup Working Capital Loans
As mentioned, ABC is able to work with any and all business owners seeking a loan. The same goes for loans for startup businesses. Oftentimes startups lack enough funding to cover the plethora of costs it takes to stay afloat. Even without an established credit score, a working capital loan designated specifically for a startup can serve as a wonderful option.
Preparing for Loan Application
Cashflow can be hard to come by during the beginning stages of starting a business. Let ABC be your loan specialist and guide you along the path to success. You’re now aware of what working capital is, how to calculate it, how to find your working capital ratio, and how to apply for five different types of working capital loans. Let’s prepare you for the actual application process.
CHECK YOUR CREDIT SCORES. And please notice that the word ‘score’ was indeed pluralized to ‘scores.’ There is your personal credit score as an individual person, and there is your business credit score as an individual business. They’re equally important when it comes to loan application as a small business owner, or frankly as an owner of any sized business.
Believe it or not, business owners have approximately a 40% better chance of being approved for any type of loan if approaching the application process with an understanding of both his or her personal credit score and his or her business credit score.
CHECK THE INTEREST RATE. Do not be afraid to shop around for potential lenders, but also be astutely aware that credit checks sometimes affect credit score itself. Ask all the right questions, such as “How will your particular credit check affect my score?”.
CHECK THE FEES. Ask about any hidden fees and ask for an itemized breakdown of the costs/rates of the loan. ABC will happily provide you with such information, and it should be expected of any other loan-handling business to do the same.
Here are three questions you should be able to answer ‘yes’ to prior to applying for any type of loan, let alone a working capital loan:
- Do you think you’ll be accepted?
- Can you afford the payments, and on time?
- Are there terms and/or conditions that potentially can’t be met?
At American Business Credit we take great pride in providing unsecured loans and lines of credit, while offering the best customer service experience. No matter if you are starting a business or already established, if you are in need of unsecured financing we are available to help. Additionally, we offer personal loans to individuals in need of cash for everything from home improvement projects to medical bills to debt consolidation.
With more than 20 years of industry experience, we ensure that you get the money you need at a competitive rate. Thanks to a simplified application process, it is easy to apply for a loan and receive funds without any delay. Regardless of your credit score and history, we will work with you one-on-one to increase your chance of finding the perfect loan product.
Our strong commitment to customer service starts from the moment you contact American Business Credit. There are no upfront fees and no cost to you if we are unable to secure the proper funding. With our industry experience, we present you with multiple options while explaining the finer details of each one.
Chris Fuller went to the University of South Florida and has worked in the financial sector for over 20 years. He has extensive experience in all aspects of personal and small business lending, from personal loans, equipment finance to cash flow based solutions for small mom and pop businesses, and large corporations.