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What is a Working Capital Loan?

Learn what a working capital loan is, how to use this type of financing in your small business, and the pros and cons of working capital loans.

 Reading Time: 4 minutes

To keep your small business afloat, you need to pay staff, rent, short-term debt, and other short-term operational expenses – this goes without saying.

But you might experience a shortfall at some point – a seasonal spike in demand, late payment from a big client, or economic downturn are a few possible culprits – and find yourself looking for short-term financing.

A working capital loan may be a good solution to the shortfall.

In this article, you’ll learn:

  • What a working capital loan is
  • Types of working capital loans
  • Working capital loan use cases
  • Pros and cons of working capital loans

Working Capital Loan Definition

A working capital loan is a loan used to cover a company’s short-term operational needs. The funds aren’t meant for long-term assets and investments, though.

Note: working capital is current assets (e.g., cash, accounts receivable, and inventory) minus current liabilities (e.g., accounts payable, wages payable, and short-term debts).

Types of Working Capital Loans

Let’s look at three working capital financing options for small business owners.

Merchant Cash Advance

A merchant cash advance (MCA) gives a business upfront cash to be repaid by deducting a percentage of credit card sales (often 10-20%) until the amount borrowed plus fees is fully paid back.

The total amount to be repaid is based on a factor rate, not an interest rate. You take the factor rate (which typically ranges from 1.1 to 1.5) and multiply by what you borrowed to calculate the total amount to be repaid.

For example, you borrow $20,000 with a factor rate of 1.2. The total amount to be repaid is $20,000 * 1.2 = $24,000.

Invoice Financing

Invoice financing is a way to borrow against outstanding customer invoices. With this financing option, your invoices are used as collateral.

Here’s how it works:

The lender gives you a cash advance, perhaps around 90% of the invoice value. You keep customer payments minus the amount advanced and the lender’s fees (typically between 1% and 5% of the invoice value).

Business Credit Card

A business credit card can be an excellent way to meet short-term working capital needs – in a couple of scenarios.

Scenario 1

You find a business credit card with a 0% APR introductory period of 6-18 months, and this corresponds with your working capital needs.

Scenario 2

You need extra working capital for a short period of time, perhaps a few weeks. At the end of this period, you expect to get an influx of cash – before the due date of your credit card payment.

Working Capital Loan Use Cases

Here are a few possible use cases of working capital loans:

Build Inventory

If you have a small business that sells physical goods, you have inventory – and your inventory needs aren’t always the same.

A new, rapidly growing small business might have inventory flying off the shelves – and may be having trouble keeping popular items in stock. In this case, building up inventory might be a good move.

Or maybe you have a seasonal business, and the holiday season is much busier than the rest of the year. Again, you might want to increase your inventory for this period.

Your inventory is a current asset, so if your business’s optimal amount of inventory is higher, you need more working capital – all other things being equal.

Increase in Accounts Receivable

As a small business owner, you might try to be flexible on payment terms.

Sometimes, this means extending customers’ payment terms. But by doing this, you increase your accounts receivable – which decreases the cash available to satisfy your short-term financial obligations.

Other times, your customers pay late – due to cash flow problems or oversights. Again, this has a negative effect on your cash position.

In any case, you might need a working capital loan to keep paying your bills.

Decrease in Operating Cash Flow

Operating cash flow is essential to the long-term survival of your small business, as cash flow from investing or financing may be less predictable.

But your operating cash flow is going to ebb and flow – no pun intended. You might have a seasonal slowdown. Or maybe the U.S. economy takes a turn for the worse.

If your operating cash flow declines, less cash is coming into your small business – which may lead to a reduction in your working capital.

Pros and Cons of Working Capital Loans

Let’s look at some of the pros and cons.

Pros

  • Fast: it’s fast to apply for a working capital loan and fast to get funding. With Gravity Capital, for example, you can accept a funding offer and get money in your account the next day. 
  • Flexible: with many types of business loans, you have to pay a fixed amount every month. But this isn’t the case with certain types of working capital loans. With a merchant cash advance, your payment adjusts with your sales.
  • Cheap (in dollars): since a working capital loan is short-term, you might pay a low dollar amount (in interest/fees) – even if your rate is on the higher-end on an annualized basis.
  • Keep equity: since working capital loans are debt financing, you don’t have to give up a piece of your company to secure the financing.

Cons

  • Higher rates: while interest/fees might be low in dollars, they are often high on an annualized basis. This means that working capital loans are a viable option if they are used once in a while, but can get expensive if used constantly.
  • Tied to personal credit: if you miss a payment(s) or default on your working capital loan, your personal credit score might be affected.
  • Collateral: some working capital loans require collateral, so you may have to put business assets at risk.

The Bottom Line

Working capital loans can be beneficial to small business owners – if used selectively.

You don’t want to be using working capital loans year-round for several years. For example, loan of this type is a short-term solution for a small business owner who constantly struggles to collect payments on time.

But they are an excellent option if you need short-term financing for a couple months each year (you have a seasonal business) or you want to power a year of explosive growth, to name a couple of examples.

If you are interested in getting a loan, check out Gravity Capital. We offer quick, easy, and affordable financing solutions to cover working capital needs.

Not sure if you need a working capital loan? Give us a call at 866-701-4700.

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