Small businesses occasionally need financing for large investments like new equipment or real estate. But even more common than that, they frequently need extra working capital to keep cash flowing for payroll, inventory and other expenses.
For instance, an ice cream parlor or swimming pool supply company may have a booming business during the summer months but little revenue during the winter. Seasonal businesses often need extra working capital during the slow months to maintain financial obligations until the busy season rolls around again. Similarly, a small consulting firm or construction business may undertake large projects that include long delays between invoicing and receiving payments. During that lag time, it can be difficult for a business to muster enough working capital to pay for utilities, rent, payroll and other obligations.
In cases like these, a working capital loan can be an easy solution for small businesses to continue thriving during cash flow ups and downs.
What's a Working Capital Loan?
A working capital loan is used to finance a business's everyday operations. The loan provides a business with capital to cover operational needs such as payroll and rent. It is not used to purchase long-term assets like equipment or real estate.
Some working capital loans work like a business line of credit, with an agreed-upon amount of cash available for the business owner to use as needed. With a line of credit, the monthly payment is based on how much has been used.
A line of credit can be open for an unspecified period of time, allowing a business owner to use, repay and reuse the funds. But a term loan is available only for a set period of time, such as 12, 36 or 72 months. A business owner is able to withdraw the funds all at once, and monthly payments include a portion of the principal as well as interest. In most cases, the loan must be repaid in full by the end of the term.
Invoice factoring is another type of working capital loan in which a business sells its accounts receivables (or invoices) to a factoring company. The factoring company will pay for the invoices, minus a service fee. Then the factoring company will collect from customers, and the small business will be able to use the capital, rather than waiting for customers to pay.
How Can a Small Business Qualify for a Working Capital Loan?
Before applying for a working capital loan, a small business should have a current, updated business plan. Lenders need to see where the business is going before agreeing to finance that future.
In addition to a business plan, most lenders will want to see three years of tax returns and financial statements from the past year. Business owners may also need to present legal documents such as franchising agreements, incorporation filings and lease agreements.
Before applying, business owners should check their credit scores and make sure there are no errors that need to be corrected.
How Can a Working Capital Loan Build Success for a Small Business?
Many small businesses do not have stable or predictable revenue throughout the year; instead, their cash flow is seasonal, with regular ups and downs. For these businesses, a working capital loan can fill in the gaps and ensure that there’s enough money available to cover expenses even during periods of low cash flow.
Even for businesses with more predictable revenue, pursuing new growth can be risky. For instance, a business owner may want to use his available cash to invest in new inventory or produce a new product line. However, with utilities, rent and other regular expenses, it may seem too risky to spend cash freely. With regular access to cash through a working capital loan, a small business can pursue new markets and other goals, with no need to worry about paying the bills on a day-to-day basis.
Make sure you read the fine print on any loan: working capital loans to small businesses are often tied to business owners’ personal credit, so missed payments or a default on the loan will negatively affect the owner’s personal credit score.
For business owners with temporary capital needs—and a solid plan to gain a return on investment—a working capital loan can be an ideal solution for keeping your business up to date on financial obligations even when cash flow is scarce.