Working capital loans can help make ends meet when scheduling issues make things difficult. Find out what they are and how to get one for your business.
My in-laws were recently in town and my in-law was lamenting the lack of progress of a farming business they had purchased in retirement. “It’s just non-stop spending. You get money and then you spend it,” he said.
You probably felt the same. Business is an endless cycle of income and expense. No matter how much working capital you start with, at some point you may need to borrow more.
Presentation: What is a working capital loan?
Working capital loans are only partially related to the accounting term working capital. In accounting, working capital is current assets minus current liabilities, which is used to measure a company’s liquidity. You look at assets that can be converted to cash within the year minus any liabilities that must be paid within the year.
A working capital loan is a code for money that you can use for anything. Most loans are tied to direct use. Home loans are used to buy real estate. Equipment loans are used to purchase equipment. Working capital loans sometimes have restrictions on uses, but usually they are just cash added to your bank account to be used at your discretion.
In general, though, it’s best if you stick to a well-defined usage. You still want to be able to tie income from loan use to loan repayment. If you have a bunch of unpaid business expenses that you’re paying off with a working capital loan without solving your income problem, you’re just kicking the box.
3 benefits of getting a working capital loan for your business
As you can imagine, there are plenty of benefits to adding more cash to your business.
1. Reduce your cash conversion cycle
The cash conversion cycle is one of the most important metrics for a retail business.
Cash Conversion Cycle = Days of Inventory + Days of Accounts Receivable – Days of Accounts Payable
The formula shows you how many days it takes to turn inventory into cash by adding the number of days the inventory is in the warehouse and the number of days it takes to collect accounts receivable (AR) and by subtracting the number of days you can retain suppliers.
If you’re running a fast-growing business, you want that cash-to-cash cycle to be as low as possible. You are trying to turn inventory and collect receivables faster and delay paying suppliers longer. This way you have more money in your account to buy more inventory and grow your business.
Working capital loans, especially revolving lines of credit as you’ll see below, allow you to take ARs out of the equation. You use ARs as collateral for the loan and get the money from the bank as soon as you declare the new AR. You can take advantage of this, of course, by buying more inventory, but also by using long payback periods to accelerate sales without worrying about money.
2. Do the payroll
Many large companies have a full cash department that manages daily cash inflows and outflows to ensure that all expenses can be paid on time. With small businesses, the Treasury Department is usually you or, if you’re lucky, a comptroller tracking the net bank account balance of outstanding checks.
Sometimes that means a check you signed three months ago finally gets deposited and you won’t have enough money to pay. Working capital loans can sustain you until you can find the money.
3. Increase your distributions
Many companies have a rule of thumb for annual distributions to owners. They distribute half of the net income, or 5% of turnover. Some owners choose to keep all their money in the business and simply pay themselves a salary. Distributions are usually tied to an income statement measure to encourage performance while leaving a business emergency fund behind.
Easy access to bank working capital makes it much easier to distribute as much money as possible. It is important to diversify your savings. The more money you leave in the business, the less you will be personally in the event of a catastrophic failure. A working capital loan may be the emergency fund you need.
5 Types of Working Capital Loans
Here are five possible ways to finance your working capital.
1. Revolving line of credit
Revolving lines of credit are the most popular type of working capital loan. The lines are approved for a maximum amount. and the amount available is determined by a borrowing base. Accounts receivable are most often collateral for the borrowing base.
Every month, you submit an AR aging report, and the bank releases 75% to 80% of the balance in the report. You won’t find many revolving lines that allow you to borrow up to 100% of the AR balance. This is because the bank needs a safety margin in case some of your customers never pay.
The intent of the line is for you to pay it back when you get paid by ARs. This is called spinning the line. The cycle allows you to make a sale, borrow against the line to make the sale, and then pay the line when you receive money.
If you borrow and never make a payment, the bank will consider your line to be evergreen. Eventually, the bank will ask you to make principal payments on the line to pay it back.
Many revolving lines have annual renewals to allow the bank to update its subscription (and collect fees) and give you the option to increase or decrease the amount of the line. If you can find a bank willing to waive annual renewals, take the deal.
2. Unsecured line of credit
Unsecured working capital lines of credit are slowly going the way of the dodo. Years ago, you could get a “signature loan,” supposedly because all it took to get the loan was your signature on the line guaranteeing it.
Today, every bank has multiple regulators reviewing its balance sheet, and any unsecured loan is over-reviewed. You might be able to get a great little loan secured by office assets (desks, photocopiers, microwaves covered in years of exploding dumplings). Otherwise, consider using a loan from the US Small Business Administration (SBA) or corporate credit cards.
3. SBA Term Loan
Have you ever seen The big court? SBA working capital loans are the new mortgages in 2005. Major banks issue government-backed working capital loans of up to $350,000 and sell them in a secondary market.
The loans have terms of 10 years and a variable interest rate. Big banks have a philosophy that the more they generate, the less impact defaults will have on the overall portfolio.
This may be a bad long-term strategy for banks, but it could work well for you. If you need to invest working capital in leasehold improvements or start a new advertising campaign, consider getting an SBA working capital loan. Payments will be high, so use cash wisely to increase operating cash flow to cover them.
4. SBA Revolving Loan
The SBA also has a revolving line of credit product. It is governed by a loan basis and has annual renewals. The line is generally structured to have a five-year drawdown period followed by a five-year term.
This means you have five years to use the line as you would any revolving line of credit, and once that term expires, you make payments over the next five years to pay off the balance. At this point, you should be able to replace the SBA line with a conventional rotating line. Generally, conventional lines are better because they have lower fees; SBA loans are for businesses that cannot get a conventional loan.
5. Credit cards
Don’t rely on credit cards for your working capital. Credit cards are good for one thing: rewards points. Unless you can legitimately get another loan, pay off your credit card balances each month and just use them for your regular operating expenses.
How to get a working capital loan for your business
Follow these steps to get a working capital loan, if the process takes weeks and weeks, don’t be afraid to jump ship.
1. Gather the documents
As with any loan, you will need to provide a ton of information to get the loan. Here is a list of likely items:
- Three years of tax returns
- Interim income statement and balance sheet
- AR and AP aging reports
- Personal financial statement (including personal balance sheet and sources of income)
- Loan application to extract a personal credit report
- management resume
2. Approach your bank
Working capital loans should be the backbone of your relationship with the bank. Walk into your usual branch and ask about your options. If they’re not good, you might want to consider moving your relationship to a new bank. If the relationship is generally good, but you wouldn’t qualify for a loan, ask your banker for advice. Most bankers keep contacts who will make loans that their bank will not.
Most banks have a simplified working capital loan process. Many approve loans under $500,000 to $750,000 with an algorithm. Keep that in mind. If the application and decision process takes forever, you can almost certainly do better elsewhere.
Cash is the lifeblood of a business, and working capital loans make it much easier to keep that cash flowing through tough times. The key is not to get addicted to loans. Whenever possible, stick to using internal company capital and cash flow, as all leverage comes at a cost.