Your Complete Guide to Working Capital Lines of Credit
Dane Panes | August 30, 2021
- Your business needs working capital to finance day-to-day expenses and move your business forward.
- A working capital line of credit can be used to bridge cash flow gaps and finance operating costs.
- You can use the funds from a working capital line of credit to address emergency expenses, prepare for peak season, fulfill large orders, and more.
Undercapitalization is often one of the biggest obstacles holding a business back. You can’t make money if you don’t have money. A lot of emerging entrepreneurs don’t have the cash to get their business off the ground – or recuperate after their business has seen some hard times. This is when many business owners start considering taking out loans.
Working capital lines of credit can help bridge cash flow gaps by providing the funds you need to run your business. It’s perfect for business owners going through tough times but is confident their business will come out on top.
In this article, we’ll take a closer look into this small business loan option and how it can help the growth initiatives of a small business.
What is Working Capital?
Your company’s working capital is the money used to finance day-to-day business expenses, including inventory, payroll, and other costs incurred while running your business. Having the working capital you need gives you more room to move your business forward.
To calculate your working capital, subtract your current liabilities from your current assets. Let’s say you own a retail business, and your current assets are $500,000 while your current liabilities are $350,000. You’d subtract $350,000 from $500,000, to get your working capital of $150,000.
Some examples of current assets include cash and equivalents, inventory, and accounts receivable, while current liabilities include accounts payable, short-term loan payments, and interest payable.
What is a Working Capital Line of Credit?
A working capital line of credit is a business line of credit primarily used to cover operating costs and other gaps in cash flow, and this can be anything from hiring and training to office rental and payroll.
Once approved, lenders will set a credit limit where you can withdraw money as needed and pay it back later. The credit limit you qualify for is primarily based on your creditworthiness and your business’s overall financial health. Unlike traditional forms of funding, you’ll only repay the money you borrowed, plus the interest – not the entire credit limit. A working capital line of credit is revolving, which means your credit limit goes back to the original amount once you’ve repaid what you’ve withdrawn.
Working capital lines of credit are ideal for filling unpredictable cash flow gaps that could otherwise create a dent in your business’ finances.
When is the Best Time to Apply for a Working Capital Line of Credit?
The answer depends on your current financial situation, that’s why it’s so important to clearly understand your business capital needs before applying.
Checking the working capital your business needs may involve plotting inflows and outflows of cash per month. For example, Christmas retailers may see a steady cash flow from September to November leading up to a revenue spike during the holidays, but then low sales for the rest of the year. However, these retailers still need to pay for expenses regardless of the season, so make sure to consider this when calculating your business’ capital needs.
When calculating your working capital, you’ll have to make educated guesses about the future based on previous results, upcoming projects, possible losses, etc. These projections help track those months when you’ll have more outflows than inflows, and identify when the cash flow gap is the widest. With this information, you’ll know when to secure funding to support your business.
Here are some of the reasons or business expenses that might justify why you might need the business financing:
- Addressing emergency expenses.
- Preparing for peak seasons and keeping the business afloat during slower ones.
- Fulfilling large orders without asking for an advance from your suppliers.
- Paying for rent, payroll, utilities, and other day-to-day expenses when you’re facing negative cash flow.
- Taking advantage of business opportunities that come your way, like bulk discounts from suppliers, investment opportunities, etc.
- Hiring and training employees to support the growth of your business.
Working Capital Line of Credit Requirements and Terms
Requirements, terms, and rates vary from lender to lender, but here are some of the general requirements when applying for a working capital line of credit:
- At least two years in business
- At least six months’ worth of bank statements
- 500 credit score
Here are some of the terms you can expect from working capital lines of credit:
The funding speed of a working capital line of credit will vary depending on the amount you qualify for. For example, you may receive a smaller business line of credit with a limit of $10,000 within the day you apply, while larger lines of credit of $1,000,000 and above could take a few more days to underwrite.
The cost of the loan and the credit rates vary depending on the lender you’re working with. Some quote monthly rates, while most lenders charge an annual percentage rate (APR). The APR includes fees like origination fees and draw fees, making it a great way to compare the costs of different lines of credit. Be sure to check in with your lender and ask about the fees and rates they charge. The rates for working capital lines of credit can vary between 10% to 80% APR. This rate depends on your business credit, and qualifications, including your personal credit score, cash flow, collateral, and more.
The loan amounts for working capital lines of credit can range from $1,000 to $5,000,000. The amount you receive also depends on your qualifications and overall business health.
Repayment terms for working capital lines of credit range from six months to five years. Your lender may renew your credit line at the end of your term if you have a good payment history.
The Advantages and Disadvantages of Working Capital Lines of Credit
Working capital lines of credit aren’t for everyone, and the best way to see whether this financing structure is right for your business is to weigh its pros and cons.
|Improve Cash Flow During Slow Seasons||Borrowing Cost|
|Flexibility of Use||Fees|
Advantages of Working Capital Lines of Credit
Let’s take a look at a few advantages of working capital loans for small businesses:
Improve Cash Flow Especially During Slow Seasons
A working capital line of credit is a great tool for ensuring you have enough cash flow throughout the year. This is an excellent option for seasonal businesses, like lawn care businesses, Christmas and Halloween retailers, and farming businesses.
For example, a lawn care company that makes the most money during spring and summer may be short on cash during the winter season. The lack of business makes it difficult for a business owner to pay for rent, payroll, or repair and maintenance. You can use a working capital loan to pay for these expenses and balance your cash flow regardless of the season.
Flexibility of Use
One of the advantages of a working capital loan is that small business owners can use it for almost any business purpose. Some of the most common ways you can use a working capital line of credit include:
- Fulfilling a large order
- Paying your employees
- Repairing broken equipment
- Paying for emergency expenses
- Hiring and training employees
A working capital line of credit is revolving. This means that you can repeatedly access your existing credit line if you pay off the balance on time. Let’s say you have a credit limit of $200,000, and you’ve withdrawn $20,000 off your credit line the past month. Once you’ve repaid the $20,000 plus interest, your credit line will return to $200,000.
Disadvantages of Working Capital Lines of Credit
Unfortunately, no financing solution is perfect, and this includes working capital loans. Here are some of the downsides of funding your business with a working capital line of credit:
Business owners often need additional working capital to address short-term expenses. Working capital lines of credit are usually structured as a short-term funding solution – processed and paid out within days. The speed of funding represents a higher risk compared to conventional bank loans that take months to underwrite. Understandably, a higher risk for lenders means higher costs for borrowers.
While the withdraw-as-needed structure of a working capital line of credit may seem ideal, the fees can quickly add up if you’re not careful. The fees vary from lender to lender, but this may include maintenance fees, origination fees, application fees, and draw fees.
Don’t fall for low interest rates just to be charged with several fees later. Do your research and compare multiple lenders by checking rates, fees, and other costs. This lets you determine whether a working capital line of credit is right for your business or you’re better off with a more affordable solution.
Working Capital Lines of Credit: Is it the Right Option for Your Business?
Applying for a working capital line of credit gives you an additional cash injection, ensuring that your cash flow gaps are covered. It provides you with the cash you need when you need it. When capital is available at your disposal, you’ll improve your business services and efficiency. But is it the right solution for your business?
It’s important to remember that working capital lines of credit are a type of short term business loans, so they’re more expensive than long-term loans. This may be an ideal solution if you need fast and flexible capital. But before you apply, be sure to weigh the pros and cons. Evaluate your business and calculate your business capital needs. Compare several lenders, as well as the fees, costs, interest rates, and terms before proceeding with your application.
Frequently Asked Questions
A working capital loan is a type of business loan that is designed to help businesses meet their short-term financial obligations, such as payroll, inventory, and other operational expenses.
It can be an effective way for businesses to manage their short-term cash flow needs and maintain their operations, especially during economic uncertainty or when faced with unexpected expenses.
There is no one "best" working capital loan that will suit every business's needs, as the most suitable loan will depend on your company's specific circumstances. Some factors that businesses should consider when evaluating working capital loan options include interest rates, repayment terms, fees, loan amounts, and eligibility requirements.
When searching for a working capital loan, businesses should compare the options available from different lenders, such as banks, credit unions, and online lenders, to find the loan that best fits their needs. It's essential to evaluate each loan's terms and conditions carefully and consider the overall cost of the loan, including any fees or charges.
Working capital involves four main components. This includes:
- Cash and cash equivalents (i.e., stocks and bonds, money market accounts, T-bills, etc.)
- Accounts receivables (A/R)
- Accounts payable (A/P)
The first three - inventory, cash and cash equivalents, and accounts receivables (A/R) - are part of your company’s assets, while your accounts payable (A/P) are considered a business liability.
Cash deposits in savings and checking accounts, highly liquid assets, and marketable instruments (e.g., bonds, stocks, etc.) are three examples of working capital.