How a Working Capital Loan Can Help Your Business

Working capital, a measure of your company’s liquidity, is part of every business. It’s critical that you pay attention to your working capital because it indicates whether you have enough money to keep operating your business in the short term.

As a small business owner, you’ll likely face instances when your working capital is not enough to cover all of your expenses. This can happen through no fault of your own—a client might be delinquent in paying a large invoice, or bad weather could disrupt your ability to sell. Working capital loans exist so that businesses can maintain operating costs even if their cash flow comes short.

What Is Working Capital?

Working capital measures how much money you have on an operational level—in a basic sense, working capital is your assets minus your debts. Calculating working capital gives you a snapshot of your immediate financial situation.

“Working capital is the money leftover if a company paid its current liabilities (that is, its debts due within 1 year of the date of the balance sheet) from its current assets,” according to a definition from the Securities and Exchange Commission (SEC).

The SEC provides a simple formula: 

• Working Capital = Current Assets – Current Liabilities

Say your business has $100,000 in current assets, like cash in your bank and inventory, and $75,000 in current liabilities, like office rent and labor costs. You would then have $25,000 in working capital.

Working capital can also be expressed as a ratio. To calculate your company’s working capital ratio, divide your current assets by your current liabilities.

For the example above, the working capital ratio would be 1.33.

Working capital is similar to cash flow, but the terms refer to different things. Cash flow is calculated as a projection for the future, while working capital refers to your balance sheet as it exists right now. Both are important to understand if you want to avoid cash crunches or when you don’t have enough money to meet expenses for an extended period of time.

What Is Good Working Capital?

If your working capital is high, your operation is likely healthy. Businesses with high working capital over a long period of time have the ability to expand with less risk involved. As your working capital gets closer to 0, it becomes harder to grow your business without overextending yourself. If your working capital is negative, you probably need to find funding somewhere in order to stay open. This is where small business working capital loans come in.

Are Working Capital Loans a Good Idea?

Unlike some business capital loans like term loans from banks, working capital loans are usually short-term. This is because you need working capital to stay in operation—these loans aren’t designed to allow you to launch an expansion effort.  

“If you are running a business and have exhausted all your options to your working capital, it may be time to consider a working capital loan,” explains Sean Peek, a small business expert with the US Chamber of Commerce.

Assuming you can make the repayments, a working capital loan is a common way to ensure you pay your expenses.

“Businesses use working capital loans to cover things like payroll, rent, and debt payments,” Peek advises. “They are also often used by cyclical businesses during the off-season—the debt of which is paid down during the busy season. This is a flexible loan option for small businesses that need cash quickly to cover immediate expenses. However, working capital loans should not be treated as a long-term funding option for something like a business expansion.”

There are many options for working capital loans—and new lenders are opening up every year. Some offer short term working capital loans or working capital lines of credit. Some alternative lending products, like invoice factoring and merchant cash advances, are used to boost working capital. Business credit cards can be seen as a form of working capital loans, too.

How Do You Calculate Working Capital Loans?

To calculate what you need as a working capital loan, return to your working capital formula. Set a goal for your ideal working capital. The difference between the assets needed to reach this goal and your current assets is how much money you need in the form of a loan. Of course, you should also factor in repaying a working capital loan as a liability and adjust that side of the formula as well.   

“Before you decide to borrow, it’s important that you know what your needs are and to make sure the numbers make sense for you and your business,” notes Marco Carbajo of the Small Business Administration (SBA). “How will you use funds? Do you expect to pay it back in a short period of time?”

What Is the Difference Between Working Capital and a Term Loan?

Working capital loans and term loans—the type of small business loans often offered by traditional lenders like banks—differ in many ways. Working capital loans are usually smaller in amount and have higher interest rates. They’re also usually approved much faster and have a less stringent application process compared to term loans. This is because term loans are meant for businesses seeking to expand, while working capital loans are pitched toward businesses that need a little funding to maintain current operations.

What Is Considered Working Capital for an SBA Loan?

The Small Business Administration offers low-interest working capital loans through various lenders. SBA 7(a) and SBA Express loans can be used for working capital, while SBA 504 loans are not permitted for this use.

SBA loans are sought after because they’re guaranteed by the US government and generally have more generous terms for borrowers.

The SBA follows the same definition of working capital as other lenders—a business’s working capital is equal to the difference between its current assets and its current liabilities. The SBA views working capital as the money needed to keep a company in operation. 

The information provided in this post does not, and is not intended to, constitute business, legal, tax, or accounting advice. All information, content, and materials available in this post are for general informational purposes only. Readers of this post should contact their attorney, business advisor, or tax advisor to obtain advice with respect to any particular matter.