Working capital loans are mostly, to fund a company’s day-to-day operational expenses, such as inventory purchases or supplier payments. These types aren’t intended to finance long term business needs.
Working capital refers to the money that a company uses to manage its everyday expenses. Cash flow is the lifeblood of a business.
Even profitable ventures can run into trouble if they aren’t able to meet their short term financial obligations. It can be tricky for small business owners to strike the right balance on their working capital. To have enough for their daily operations, while maintaining excess cash lying around.
Working Capital Liquidity
It’s important to be aware of how much your working capital is available for use. That’s because your current assets may not all be in the form of cash. For example, a portion of your current assets may be tied up in inventory or accounts receivable. As such, it’s important that business owners get a sense of their weekly cash flow to avoid running into payment issues.
Uses of Working Capital Loan
Depending on your business, as well as the industry you’re in, there can be a variety of working capital needs. Below are common reasons why small business owners obtain working capital loans:
1. Capitalise on time-sensitive business opportunities
With external financing, you’ll be better positioned to capitalise on business opportunities that you may otherwise have to pass on – such as making bulk purchases to take advantage of supplier discounts, or investing in expansion activities that’ll help your company grow.
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2. Manage seasonal fluctuations
It’s not uncommon for seasonal businesses to rely on working capital loans to even out their cash flow across the high and low seasons. For example, to prepare ahead for the busy season, a restaurateur may obtain external financing to cover the costs of inventory purchases, marketing activities and hiring temporary staff.
3. Purchase equipment or software
Having up-to-date equipment and software can help bring about productivity gains for your company in the medium run – yet the may be too costly to bear upfront. With a working capital loan, you’ll be able to obtain the tools you need without putting a dent
Types of Working Capital Loans
A wider range of financing solutions are now more accessible to small business owners with the rise of alternative lenders. Here’s a quick overview of common types of working capital loans available:
As its name suggests, repaying short term loans should be within a short period of time – typically six months. Repaying the loan will be in regular installments, along with the lender’s fees and interest.
Compared to long term loans, short term loans offer lower maximum loan amounts and carry higher interest rates. These loans often come with more flexible lending terms and are easier to qualify for. Hence, a great financing option for newly established ventures.
Credit line, also commonly known as revolving credit provides business owners with access to a pre-approved sum of capital. It helps to think of a line of credit as a credit card; it’s a facility you can draw from as and when you need. Interest is charged only on the amount that is drawn. Your credit limit goes back up when the amount drawn is repaid.
Invoice financing is a short-term financing solution that enables businesses to borrow based on their unpaid invoices. By using your accounts receivables as collateral, you’ll obtain an advance of 70-90% of your outstanding invoices through your lender. Once your customers pay up their invoices, you’ll receive the remaining balance (less the factor and processing fees).
A merchant cash advance (MCA) isn’t a loan, but a lump sum payment that an MCA provider advances. It is based on your credit card transactions. Until the full repayment is made, you’ll then hold back a percentage of your daily or weekly credit sales. It’s a financing option that lends itself to businesses that receive the majority of their payments through credit cards. The business varies, such as restaurants, beauty salons
Which working capital loan is right for my small business?
A checklist of key pointers can help you better determine which financing solution will fit your needs best. Below are some questions and pointers to include in your list:
• How quickly do I require funding?
Depending on your loan purpose, you may or may not be able to wait for several weeks to gain access to funding – as is the case for situations such as urgent equipment repairs, or when you require external financing to fund a large scale business project.
Traditional lenders may not be a good fit in these scenarios. That is due to tendencies to have rigorous application process and lengthier onboarding periods by these lenders. It’s common for businesses to have to wait several weeks to hear back about the status of their loan application.
• Will the loan improve my business’ financial position?
Certain types of financing solutions, such as merchant cash advances carry hefty fees and may require daily repayments. As such, things may quickly spiral out of control if small business owners aren’t able to keep up with the payments. They may wind up in a debt spiral, taking out multiple loans in succession in order to pay off the outstanding balance on previous advances.
Before you commit to a loan, you need to be absolutely sure that you’ll be able to meet the repayments in a timely manner. Moreover, that the benefits it brings to your business outweighs the costs.
• Do I understand the real cost of the loan?
As with any kind of business loan you choose to take up, it’s essential that you pay close attention to the repayment terms. Along with it, it is advised to fully understand all possible fees you may be liable for. Always request for a full breakdown of the fees involved. Keep an eye out for terms that allow for changes in the interest rate, as well as loan acceleration clauses.
• What’s the ROI of the loan?
Obtaining external financing can be key for growth. It may not be, however, a good fit for your business depending on your current situation and financing needs. “Will borrowing earn me more money than it costs?” is an important question you’ll need to answer to assess the ROI of the loan.
Ideally, funds obtained are used for investments or activities that will produce growth or revenue. Alternatively, to create a significant reduction in your costs such as inventory purchases or equipment repairs.
• Don’t confuse short-term working capital needs and longer-term business financing requirements
Simply put, working capital is use to pay off short term obligations. Long term financing are related to investments or activities that impact upon the long term growth of your company. Some of them are major renovations, expansion to a new location or equipment purchases.
It is key to distinguish these two types of financing needs to avoid choosing financing solutions that aren’t a good fit for your business needs.
Here’s an example: The best option for short term financing needs is a credit line. Due to the flexibility it offers, business owners can draw from the line at anytime. Furthermore, there aren’t restrictions on what to use the funds for. However, if a borrower were to use up the line for longer term, this will limit access to finance urgent expenses.
Some tips for approval on your loan application
Getting a working capital loan? These are a few tips that’ll give you a leg up for approval in your application:
1. Provide a good reason and clearly defined use case for the loan
Top two reasons why you need to provide a clearly defined loan purpose. First, it allows lender to assess if the loan, or other alternatives, will be a good fit for your business. Second, to evaluate if your business will make a good investment.
To foster trust with your lender, you’ll need to show a clear plan for your funds. Additionally, how it contributes to the growth and success of your venture. For example, if you’re obtaining funds for marketing activities, it helps to prepare a summary of previous successful projects. Furthermore, it indicates how you’ll be using the loan to further replicate these successes.
2. Clean and clear accounting in bank statements
Lenders want to see a clean bank statement, one that shows regular deposits, a healthy bank balance and no overdrafts. It’s an indicator that you’re on top of your business finances, and will likely make a reliable borrower.
Past overdraft records will not blow the chances on approval for your loan application. You’ll need to provide background information on the situation and why you need access for the funds. Also, some details such as the dates and account number. Highlight that this is a one-off incident, and show how you’ve implemented measures to prevent similar incidents from occurring.
3. Provide documents that support your cash inflow projections
In reviewing your cash inflow projections, lenders want to assess that these projections are realistic. In addition, they’re also looking if you’ve left a reasonable amount of wiggle room. So when an unforeseen expenses crop up, you’re able to meet your loan repayments.
Therefore, it’s important to include documents that will support your cash inflow projections in your application. The documents are recent invoices, aged list of debtors, evidence of confirmed orders or contracts, up-to-date management accounts and transactional data (for B2C businesses).
4. Build up your personal credit score
For small businesses with no solid credit history, lenders rely much on your personal credit score to assess your application. That’s because it’s an indicator of how reliable you are with your financial obligations; it is safe to assume that business owner with a pristine personal credit record is reliable. Moreover, be timely and consistent with their working capital loan repayments.
- Working capital loans are for short term financing needs. These loans are typically to capitalise on time-sensitive business opportunities. manage seasonal fluctuations or to create a cash cushion.
- Common types of working capital loans include: short term loans, invoice financing, business lines of credit and merchant cash advances.
- A checklist of essential pointers is critical for helping you evaluate loan options that will best meet your needs. Some key questions you’ll need to ask yourself include: “How quickly do I require funding? What’s the ROI of the loan?”
- Some tips to maximise the chances of getting your loan application, approved:
- Provide a good reason and clearly defined use case for the loan
- Have clean bank statements
- Provide documents that support your cash inflow projections
- Your personal credit score weights in your lender’s decision to approve your application. You’ll need to work towards building your credit score up to where you want it to be.