Small Business Loans for Working Capital
- April 6, 2018
- Posted by: Jeff Gitlen
- Category: Small Business Loans
If you run a small business, you know how vital it is to always have enough cash on hand to pay your bills, respond to unforeseen problems, and take advantage of sudden opportunities. Whether it’s paying for an important marketing campaign, meeting your payroll obligations, or paying your vendors for goods and services, you need to have sufficient resources to do what is necessary to sustain and grow your business.
Cash, and other assets easily turned into cash, is part of working capital, defined as current assets minus current liabilities. A current account is one that is expected to be used or paid within a year. Current assets include cash, short-term notes, accounts receivable, and inventory. Current liabilities are made up of accounts payable, salaries payable, and rent payable, to name a few. The extent to which your current assets exceed your current liabilities is a measure of your business’s efficiency and short-term financial well-being.
Small Business Loans
One of the standard ways to shore up working capital is through a small business loan, which can immediately infuse cash into your company. Small business capital loans usually involve relatively modest amounts of money, often well under $1 million. Because these loans are small from a business perspective, they often carry less restrictive terms.
Small business loans can be uncollateralized, in which the lender is trusting in the borrower’s creditworthiness, or collateralized, where the lender can take possession of property pledged to offset the loan’s risk should it go unpaid.
At one time, banks were the originators of almost all small business loan volume. This changed in recent decades with the advent of alternative lenders, especially after the banking disaster of 2008. The internet features dozens of online commercial lenders as well as peer-to-peer lending portals that allow small businesses to shop around for the best terms available.
Alternatively, factors are willing to make loans collateralized by a company’s accounts payable or inventory. Some of the best terms are available on loans guaranteed by the Small Business Administration. The SBA will guarantee up to 80 percent of an eligible loan’s principal through a variety of financing programs.
Working Capital Loans
Working capital loans are geared towards stabilizing a company’s soundness in the face of challenging cash flows. They are meant to be short-term loans that help a company pay its bills. They are not meant for long-term projects such as construction of new stores or acquisition of expensive equipment – other types of loans are better suited for long-term needs.
A healthy company normally has a working capital ratio (current assets divided by current liabilities) between 1.2 and 2.0, although this varies by industry. A ratio below 1 indicates that liabilities exceed assets, a situation that can lead to loan payment delinquency and bankruptcy. A long-term decline in working capital signals a significant problem that must be addressed. It could mean that sales are declining, account receivables are going uncollected, the business’s expenses are too high, or other operational problems.
Inefficient operations might mean that too much money is tied up in inventory or accounts receivable. Although most of their value can be eventually converted to cash, these assets can’t be used directly to pay the company’s obligations. A working capital loan can tide over a business until the operational issues are settled. An affordable loan makes sense if you expect cash flows to improve, and you want to avoid fire-sale pricing of your inventory or selling off your invoices at a deep discount just to raise cash.
Working capital loans have several benefits:
Protect Your Own Money
It might be tempting to use your personal money to supplement your business’s working capital, but borrowing makes more sense, especially when your business is a legally separate entity with limited liability. That’s because only the company’s assets can be attacked by creditors, while your home, car, and personal property are shielded.
Handle Financial Contingencies as They Arise
When your cash runs low you might delay payments to creditors, thereby lowering your credit score and making new credit costlier and/or harder to get. Bankruptcy looms if things get out of hand. A working capital loan can get you past the rough spots while preserving your creditworthiness.
One alternative to borrowing is to take on partners, like equity investors, who will inject capital into your business. However, this means you’ll be forfeiting some of your decision-making power, and you’ll be receiving lots of suggestions you might not want. A loan lets you maintain 100 percent control of your company as long as you don’t default on the loan. In other words, a loan frees you from outside interference.
May Require No Collateral
If you get an unsecured business loan, you don’t need to pledge your assets to back up the loan, thereby increasing your flexibility to use those assets.
Short-term working capital loans are usually quickly obtained and can be used as you see fit.
Potential Risks and Costs
If you fail to repay on time, you risk default, a ruined credit rating, and bankruptcy. Remember, investors get paid after lenders during bankruptcy proceedings. You can end up with nothing.
Collateral May Be Required
If you don’t qualify for an unsecured loan, you’d have to pledge some assets as collateral. This puts these assets at risk, and you can’t dispose of them until the loan is repaid.
The riskier the enterprise, the higher the interest rates you’ll be charged. Paying interest, although tax-deductible, still drains money that could be used for other purposes.
Don't Address Long-Term Problems
The short payback periods of these loans means they are not meant to solve long-term problems like new construction, rehabilitation, expansion, and so forth.
Are Working Capital Loans Worth It?
Small business capital loans make sense if your company has a relatively good credit rating, but is undergoing a temporary rough patch. Many of these loans have favorable repayment terms, except if your credit history is bad or scant. Unless you have serious doubts that you’ll be able to repay on time, working capital loans make a lot of sense. They are easily applied for, quickly decided, and usually feature convenient terms. With so much competition among lenders, try using both online and brick-and-mortar loan brokers to get the best deal possible.