Your Complete Guide to Working Capital Lines of Credit
Ezra Cabrera | August 30, 2021
Key Takeaways
Your business needs working capital to finance daily operational costs and move your business forward.
A working capital line of credit can 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. Many 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 businesses 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 are 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 finances day-to-day business expenses, including inventory, payroll, and other costs incurred while running your business. Having the necessary working capital gives you more room to move your business forward.
To calculate your capital, here's the operating working capital formula: 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 draw funds 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.
Where Can You Get Working Capital?
There are a few different ways to get working capital, including:
Bank loans: Banks are a traditional source of working capital for businesses. They offer a variety of loan products, including term loans, lines of credit, and SBA loans.
Credit unions: Credit unions are another option for working capital loans. They often offer lower interest rates and fees than banks.
Online lenders: Online lenders are a newer option for working capital loans. They offer quick and easy approval and often have lower interest rates than banks or credit unions.
Government agencies: Government agencies, such as the SBA, offer various loan programs for small businesses. These programs often have lower interest rates, transaction fees, and more than traditional loans.
When choosing a source of working capital, it is important to compare interest rates, fees, and terms. You should also consider the lender's experience with small businesses and their reputation.
When is the Best Time to Apply for a Working Capital Line of Credit?
The answer depends on your current financial situation, which is 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 to a revenue spike during the holidays but low sales for the rest of the year. However, these retailers still need to pay for expenses regardless of 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. This information lets you know when to secure funding to support your business.
Here are some of the everyday business expenses that might justify why you might need the business financing:
Address emergency expenses.
Prepare for peak seasons and keep the business afloat during slower ones.
Fulfill large orders without asking for an advance from your suppliers.
Pay for rent, payroll, utilities, inventory purchases, and other day-to-day operating expenses when facing negative cash flow.
Take 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
650 credit score or higher
Minimum $20k/mo in revenue
Here are some of the terms you can expect from working capital lines of credit:
Funding Speed
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.
Credit Rates
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 origination and draw fees, making it a great way to compare the costs of different lines of credit. 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.
Amounts
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.
Term Lengths
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.
| Advantages | Disadvantages |
|---|---|
| Improve Cash Flow During Slow Seasons | Borrowing Cost |
| Flexibility of Use | Fees |
| Revolving Funds |
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, 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 winter. 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
Revolving Funds
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 have withdrawn $20,000 from your credit line in 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:
Borrowing Cost
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 than conventional bank loans that take months to underwrite. Understandably, a higher risk for lenders means higher costs for borrowers.
Fees
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, origination, application, and draw fees.
Don't fall for a low-interest rate just to be charged 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 whether 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 your cash flow gaps are covered. It provides you with the cash you need when you need it. When capital is available, you'll improve your business services and efficiency. But is it the right solution for your business?
It's' important to remember that a working capital line of credit is a type of short-term financing, 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 calculBefore proceeding with your application, compare several lenders, as well as the fees, proceeding with your application.
Common Questions. Straight Answers.
A working capital loan is a business loan 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.
About the Author
