Working Capital Loan Guide

Every business needs working capital (i.e. the money to fund daily operations). These funds can be used for a myriad of purposes, from payroll to property expenses. However, many businesses struggle to have working capital on hand due to seasonal fluctuations or cash-flow issues. In either case, a working capital loan is a popular option for many small to mid-sized businesses.

So, how is a working capital loan different from other business loans? Are there different types of working capital loans? If so, what do they each offer? Finally, is a working capital loan right for you? In today’s guide, we will answer all of these questions and more, but first, let’s go over some of the most essential information you need to know before applying for a working capital loan.

What Is A Working Capital Loan?

As previously mentioned, working capital refers to the funds you need to maintain your daily operations. Therefore, the meaning of a working capital loan is simply a type of financing that is designed to provide quick cash to cover regular business expenditures. Funding working capital with a loan is a great way to overcome temporary cash shortages. However, it is not advisable to view this type of loan as a long-term financial strategy for your business.

For example, let’s say that your business experiences a slow season during the winter months. This means that you are extremely busy and have plenty of working capital for 8 months out of the year. However, as the slow season sets in, you find yourself with higher expenses and lower income. For this reason, you might want to finance for working capital with a loan or a working capital line of credit. This will allow you to fund your business with an influx of cash (or credit) that can be paid off once your busy season returns.

Working Capital Loans Vs Business Loans

A traditional small business loan has several important caveats for applicants. First and foremost, the vast majority of banks and lenders will only give out a term loan or extend a line of credit to businesses that have been in existence for at least two years, have excellent credit, and have assets or collateral (though the last one can be avoided with an unsecured loan). Naturally, this eliminates thousands of businesses and startups from getting access to the funds they need.

Alternatively, all kinds of businesses have access to working capital loans, as long as the funds are intended for regular expenditures. For example, you can still get a working capital loan if you have been in business for less than two years and have mediocre credit, but the funds are not meant for business expansion (like hiring more employees, renting new properties, buying new equipment, etc). They are meant to help pay for day-to-day costs during slow periods or cash flow shortages.

That said, lenders will not follow up to see how your business has used the cash. So, technically, you can use short-term working capital loans as you see fit. However, be aware that you will need to pay the loan back after a relatively short period of time, and if you take out the loan and do not use it to cover basic expenses, you could find yourself in a tough position once you need to start making payments.

Thus, the primary differences between traditional business funding through a loan and funding through a working capital loan are the requirements to apply and the intended use of the funds. Traditional business loans require a lot more paperwork and a history of fiscal responsibility, while working capital loans are far more accessible and flexible. Additionally, most small business loans are used to expand a business, while most working capital loans are used for daily business expenses.

Types Of Working Capital Loans

There are actually various types of financing options that fall under the umbrella of a working capital loan. However, the two most common types are secured and unsecured working capital loans. A secured loan requires you to put up some kind of collateral that, if you default on the loan, can be taken by the lender. For example, you could use personal assets, business assets, property, or equipment as collateral. Alternatively, an unsecured loan means that you can get fast working capital without the need to provide any collateral. The latter option may result in less favorable interest rates or repayment terms because it poses a greater risk to the lender.

Many lenders also delineate between a short and long-term working capital loan, however the former is far more common and beneficial to businesses. Typically, the kind of business that needs a working capital loan needs a quick influx of cash that can be paid back within a few months. A long-term working capital loan will accrue far more interest and therefore may not be as useful.

It is also important to note that payroll funding is a unique type of working capital loan. Unlike Merchant Cash Advances (MCAs) that take a cut out of future sales or invoice factoring in which you sell a portion of your unpaid invoices to a third party, payroll funding functions like a traditional short-term loan that is solely dedicated to fulfilling your payroll obligations. Since many seasonal businesses struggle to keep employees paid year-round, payroll funding is one of the best types of working capital loans because there are few barriers to entry and the rates are extremely competitive.

Common Working Capital Uses

While business owners are free to use working capital funds for any business costs, they are best reserved for the essential expenses needed to keep a business up and running. This means that, rather than investing in new ventures or growth, working capital loans for small businesses should be put toward day-to-day costs, including but not limited to:

• Payroll – Most businesses have at least one employee on the payroll. As a result, providing consistent paychecks is vital to keeping a business operational. When a slow season arrives, some businesses have to cut back on staff just to make ends meet. With a working capital loan or payroll funding, you can keep your staff year-round.
• Inventory – Replacing inventory can be costly, especially when you have poor cash flow. For retail businesses, this is one of the most common reasons to acquire short-term working capital loans.
• Rent or Mortgage – Like payroll, rent or mortgage expenses have to be paid on time, every time. If you don’t have your regular revenue coming in, some type of loan or credit line is a must. A working capital loan is often one of the easiest ways to solve this issue.
• Debt – It may seem strange to take out a loan to pay off debt, but if you have long-term debt and seasonal slow periods, you will need an influx of cash to continue making your existing debt payments.
• Operational Expenses – Naturally, all of the aforementioned costs could fall within the category of “operational expenses,” but each business has unique operations that must be considered. For example, you may have to maintain business equipment on a regular basis or pay for seasonal marketing campaigns.

Do you need to apply for a working capital loan to help cover payroll? Are you interested in learning more about payroll financing? If so, feel free to reach out to Payro Finance today!

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