What Are Working Capital Loans and How Do They Work?

The failure rate of small businesses shows exactly how difficult it is to survive in the competitive markets of today. The fact that the main reason for this is cash flow problems indicates that working capital loans can become ‘lifesavers’ for many companies struggling to keep afloat. However, despite its efficiency, this tool will only work when used correctly. Therefore, it’s essential for business owners to understand when exactly they should use this type of financing and how much money they can afford to borrow.

Understanding Working Capital Loans: 3 Basic Questions Answered

What is a working capital loan?

A working capital loan is a loan that a business can take in order to obtain working capital to cover its immediate needs. This is a loan only fit for using in short-term, so one shouldn’t rely on it to finance long-term plans. These loans usually have very high interest rates, so they should be repaid as fast as possible.

The majority of working capital loans are secured with the company’s assets. However, many lenders today are more flexible about their terms than traditional banks and credit unions. Therefore, you should look up reliable sources that have working capital loans explained. They will provide you with a list of top lenders so you can study their individual terms. Those financing sources often provide unsecured loans that have minimum eligibility requirements. Therefore, they are available even to new businesses and those with a bad credit score.

How does a working capital loan work?

A working capital loan works like any other loan, only you use it to cover the everyday expenses of your business. This type of loan can be a good choice for businesses that depend on seasonality, as it will tide them over through a slow period. It’s the same for any company that experiences a shortage of liquid assets due to some issues and needs some cash flow to get back on track.

The most common uses for working capital loans are:

  • Wages
  • Hiring new stuff to handle a holiday rush
  • First time payments of increased business insurance premiums
  • Important and immediate purchases (for example, some type of supply is available at a great discount if you buy it in bulk on a time-limited offer)

How to calculate the size of the working capital loan you need?

The logical way to determine the size of a working capital loan you need is to calculate your working capital. Then, consider how much money your business actually has, and take out a loan to meet your needs. You can use a Net Working Capital Needs Calculator to help you.

However, business loans aren’t that simple. In the majority of cases, a company might not be able to take out a loan to match their needs exactly because they can’t afford to repay it. The cost of the loan as well as its impact on your revenue projections must be considered when calculating the amount.

How to Make Sure a Working Capital Loan Truly Helps Your Business

A working capital loan can literally make or break your business. Therefore, it’s imperative to consider this financing very carefully. Taking a loan will provide your business with the cash to meet its immediate needs, which can help you either gain an advantage or avoid failing.

The main concern in regards to working capital loans is their high interest rates. Those are the reason why this kind of financing is only viable as a short-term stopgap measure. If you try to use it for a while, your revenue might not be able to cover all necessary business expenses as well as the cost of this new loan.

Note that missing payments on working capital loans is extremely bad. Not only does this make your debt grow fast, which can put you in a position worse than the one that made you seek financing in the first place. But the missed payments will also lower your credit score. If you use the services of online lenders, this would be your personal credit score, not the company’s. This will make it harder to obtain any financing in the future.

Therefore, you need to do your calculations carefully and make sure that you borrow only the amount of money you can afford. In this particular case, it’s best to go with less than take out a bigger loan than you need, which comes with bigger interest rates and other issues.

The good news is that obtaining that kind of loan won’t be a problem at all. Online lenders today make this process easy and you don’t even need to provide any excessive paperwork to prove your need for a working capital loan. Banks are very reluctant in giving loans to small businesses today, so alternative lenders might be your only chance to get the money you need to keep your company.