Within the United States alone, 99% of all businesses fall within the small business category. Small businesses make up nearly 50% of all employment opportunities in the country, and they unsurprisingly account for a significant portion of annual revenues each year.
Although the ability to start and run a successful business is an option for just about anyone with motivation and a great idea, maintaining a profitable company is not always as easy as it seems. In many cases, businesses struggle to keep the doors open due to a lack of financing.
Understanding Working Capital
Working Capital Loans – the money used to manage everyday business expenses – is one of the first places where business owners fall short. You can calculate working capital by taking the difference between a company’s current assets (cash, inventory, and accounts receivable) and liabilities (debt, accounts payable, etc.).
In other words, it’s the money that you have to work with on hand. It’s easy to calculate, but it’s not so easy to maintain a positive working capital for your company. Sometimes, companies turn to working capital loans when they are in need of cash.
With a working capital loan, businesses have the ability to keep the operation running when cash flow is inconsistent or low. Alternately, this loan could be used to take advantage of growth opportunities when they arise. It is important to understand how working capital impacts a business, alongside the advantages and caveats of working capital loans.
How a Working Capital Loan Can Help a Business
Working capital loans are a common choice for funding short-term expenses in business. Here are a few reasons why:
Managing Inconsistent Cash Flow – A working capital loan helps small businesses when clients are slow to pay invoices or inventory is stagnant for a period of time. With a working capital loan, business owners can ensure the lights stay on and employees are paid on time.
Seasonal Sales – Some businesses bank on busy seasons, so sales and cash flow are seasonal. During a seasonal low, a working capital loan may help cover seasonal overhead expenses to keep the doors open. These funds may also help with purchasing larger amounts of inventory before a holiday or seasonal rush.
Growth Ventures – Working capital loans may be a great choice for businesses that are planning to expand. Whether it is to pay for new marketing initiatives, hire new talent, or training employees, a working capital loan can cover these new expenses.
New Equipment or Expansion – Companies may lean on working capital loans when there is a need for a material investment. Purchasing updated equipment or more inventory are common uses of working capital loans. Some people may not want to make the investment, but the potential growth may outweigh the debt.
Cash Safety Net – Working capital loans can be a smart, short-term solution for businesses with little cash on hand. This can be thought of as an emergency fund. It can be used to pay for unanticipated expenses to ensure the business remains open and employees are paid on time. This is related to managing cash flow, but it’s characterized by a more immediate need in an emergency.
Drawbacks of Working Capital Loans
A working capital loan can be helpful in a cash crunch, but there are caveats to consider. Here are a few common issues that come with working capital loans:
Higher Cost – Some working capital loans may come at a higher cost than conventional small business bank loans. Working capital loans present a greater risk to the lender. Businesses may be required to pay higher interest rates as a result.
Short-Term Nature – Working capital loans are meant to be short-term cash infusions. This means you can get funding quickly in a pinch, but it also means that repayment is typically short. Shorter loan repayment terms are often associated with higher monthly payments. These payments could create budgeting issues, so businesses need to consider their ability to repay the loan.
Collateral Requirement – Some lenders only offer working capital loans if they are secured, so collateral would be required from the business owner. This adds additional risk for the business owner whose collateral is at stake.
Are There Any Alternatives?
There are alternatives to working capital loans that may fit a business owner’s needs for short-term capital.
Merchant cash advances allow businesses to receive cash quickly based on revenue from credit and debit card transactions. This funding method may come with higher total costs than a working capital loan, but it may be easier to pay off through daily or weekly credit and debit card revenue.
Business credit cards may provide funding quickly to companies in need. However, the potential for business credit cards may be hampered by a lower credit limit compared to working capital loans.
Businesses may look to invoice factoring as an alternative to working capital loans. Invoice factoring requires selling off available invoices to a third party for a percentage of their value. The business then relinquishes responsibility for collecting on the invoices to the third-party factoring company. This method offers similar benefits to a working capital loan in terms of speed and funding, but it may come at a much higher cost in terms of lost revenue.
By Andrew Rombach, a Content Associate from fintech startup LendEDU – a consumer education website and financial product marketplace.