Working Capital Business Loans Keep Things Moving
Small business owners know proper cash management is crucial to a successful venture. But many businesses still experience occasional cash flow crunches. Handling these challenges is part of the responsibilities of small business owners. Some meet the obstacles by utilizing working capital business loans, providing an injection of funds to bridge the gaps. First, a quick refresher on the basics of such financing.
What is Working Capital?
The amount of net working capital demonstrates a business’ ability to meet short-term obligations (coming due within one year) out of existing resources. The more working capital the better, at least from a liquidity point of view. Remember, every small business owner should be able to quantify and evaluate this metric for their company.
How to Calculate Working Capital
Fortunately, the net working capital calculation is relatively straight forward and can be found on any balance sheet:
Working Capital = (Current Assets – Current Liabilities)
Current assets generally includes cash and equivalents, accounts receivable (outstanding invoices or bills) and inventory. Current liabilities encompass accounts payable, short-term debt and other accrued liabilities.
The operating working capital concept can also be viewed another way:1
Cash Balances
– + Inventory
– + Accounts Receivable
– + Prepaid Expenses and other operating current assets
– Accounts Payable
– Taxes Payable
– Accrued Expenses and other operating current liabilities
What is a Working Capital Loan?
As the name implies, these loans provide the operating capital small businesses need to keep day-to-day operations running smoothly. Working capital loans are not designed to be long-term financing needs, such as building a plant or expansion. Rather, they are designed for shorter term needs such as meeting payroll, paying vendors, buying inventory or servicing their debt.
Other obligations might include employee health insurance premiums or more sensitive needs like employee assistance plans, EAPs. Also, certain lenders don’t actually require the loan proceeds be used specifically for working capital purposes.
Types of Working Capital Business Loans
Here are some different working capital loans to consider:
Cheapest Working Capital Loans: SBA Loans
Small businesses may obtain financing through the U.S. government’s Small Business Administration (SBA). The SBA assists American small businesses by guaranteeing loans originated by their private partner banks nationwide. This ‘backing’ helps private lenders extend credit to businesses they may have otherwise rejected. One specific loan to consider is the SBA’s ‘Caplines’ program, “designed to help small businesses meet their short-term and cyclical working capital needs.”2
SBA financing is typically the cheapest form of business funding. Rates are capped and may be quoted as a spread, or amount, above a bank’s prime rate. But there are reasons why these loans have such a relatively low interest rate for business borrowers-the requirements are strict.
Requirements for many SBA Loans:3
1. Be “for-profit”.
2. Demonstrate a need for the loan proceeds and use them for a ‘sound business purpose’.
3. Use alternative financial resources (including personal capital) before applying.
4. Actually be a small business (as defined by the SBA’s average annual employment and average annual receipt standards).4
Which Industries Qualify for SBA 7(a) Loans?
· Farms and Agricultural businesses
· Privately-owned medical facilities (hospitals, clinics, emergency outpatient facilities and labs).
Who Does Not Qualify for an SBA 7(a) loan?
· ‘Speculative’ businesses (oil and gas companies)
· Gambling companies (even legalized gambling) if it comprises over a-third of annual revenue.
· Financial lenders such as banks, leasing companies and factors (factoring companies).
Finally, even if your business does qualify, the entire process can take weeks or even months until funding.
Fast Business Loans
There’s good news if your small business needs capital-fast. The last decade has seen many new lenders with very efficient distribution methods enter the enterprise lending space. Many offer online small business loans which can be funded, in some cases, as fast as same day.
Some financial technology companies like Ondeck Capital and Kabbage loans are even working on real-time funding technologies. The ability to obtain quick business loans has never been easier for small businesses.
Keep in mind, fast funding comes at a cost. Unsecured, short-term loans can be pricey and often have double-digit rates. Increasingly, computer algorithms analyze your specific data (industry, revenues, operating history and credit scores) for your personalized rate. Obtaining a loan may also require a personal guarantee from the business owners.
Invoice Financing
Another small business working capital loan is invoice financing (also known as A/R or accounts receivable financing). This type of invoice finance provides quick business capital using your outstanding invoices as collateral.
It is different from invoice factoring, which actually sells the unpaid invoices to a factoring company, invoice financing is not an asset sale. In this situation, when the late paying client (known as the account debtor) remits payment, your business receives the full amount, less a factoring fee of generally 2%.
Since, these receivables (unpaid invoices) are securing the loan, it’s a much cheaper option than unsecured loans, such as small business credit cards or an unsecured business line of credit.
The Importance of Working Capital Management
In simplest terms, working capital is a gauge of a business’ liquidity. Analyzing the working capital ratio can provide valuable insight into your business’ liquidity position.
Calculating the Working Capital Ratio:
WC Ratio = Current Assets/Current Liabilities
From a liquidity perspective, the higher the [positive] number, the better. However, a ratio of less than 1.0 portends financial distress, especially if there are industry issues or operational hiccups. Now, a business may survive amidst with a negative working capital situation as long as they’re making required debt payments. But this is a very slippery slope to navigate.
Most small business failures are the result of poor cash flow management. Cyclical operations might consider working capital business loans to provide a capital buffer or, in extreme examples, a financial lifeline.
Business owners should remember, the time to tap working capital business loans is when you don’t “need” them. As counter-intuitive as it sounds, the concept is crucial to understand. When any lender can sense a borrower is desperate for funding, the terms and conditions they’ll be forced to accept could be expensive.
1From an HBS article entitled, “Note on Free Cash Flow Valuation Models”.
2,3https://www.sba.gov/offices/district/mt/helena/resources/lenders-introduction-sbas-capline-programs
4https://www.sba.gov/sites/default/files/files/Size_Standards_Table.pdf