My in-laws were recently in town, and my father-in-law was lamenting the lack of progress of a farm business they’ve purchased in retirement. “It’s just non-stop spending. You get cash in and then you spend it,” he said.
You’ve probably felt the same way. Business is a never-ending cycle of revenue and expenses. No matter how much operating capital you start with, at some point you could end up needing to borrow more.
Overview: What is a working capital loan?
Working capital loans are only semi-related to the accounting term working capital. In accounting, working capital is current assets minus current liabilities, which is used to measure the liquidity of a business. You’re looking at assets that can be converted to cash within a year minus all the liabilities that need to be paid within the year.
A working capital loan is code for cash you can use for whatever. Most loans are tied to a direct use. Real estate loans are to buy real estate. Equipment loans are to buy equipment. Working capital loans sometimes have restrictions on the uses, but usually they are just cash added to your bank account to be used at your discretion.
In general, however, it’s best for you to stick to a well-defined use. You always want to be able to tie revenue from a loan use to a loan payment. If you have a bunch of unpaid business expenses that you pay off with a working capital loan while not fixing your revenue problem, you’re just kicking the can down the road.
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 = inventory days + accounts receivable days - accounts payable days
The formula shows you how many days it takes to turn inventory into cash by adding the number of days inventory sits in the warehouse and the number of days it takes to collect accounts receivables (ARs) and subtracting how many days you can hold off vendors.
If you run a fast-growing business, you want that cash conversion cycle to be as low as possible. You try to turn inventory and collect receivables faster and push off paying vendors longer. That way you have more cash in your account to buy more inventory and expand the 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 the ARs as collateral for the loan and get the cash from the bank as soon as you report the new AR. You can take advantage of this, of course, by buying more inventory but also by using long payback terms to juice sales without worrying about cash.
2. Make payroll
Many big companies have an entire treasury department managing the daily inflows and outflows of cash to make sure all expenses can be paid on time. With small businesses, the treasury department is usually you, or, if you’re lucky, a controller keeping track of the bank account balance net of outstanding checks.
Sometimes this means a check that you signed three months ago finally gets deposited, and you won’t have enough cash to make payroll. Working capital loans can sustain you until you’re able to come up with the cash.
3. Increase your distributions
Many businesses have a rule of thumb for annual distributions to owners. They distribute out half of the net income, or 5% of revenue. Some owners choose to keep all cash in the business and simply pay themselves a salary. Distributions are typically tied to an income statement measure to incentivize performance while leaving a business emergency fund behind.
Easy access to working capital from the bank makes it a lot easier to distribute out as much cash as possible. It’s important to diversify your savings. The more cash you leave in the business, the worse off you will be personally if there is some sort of catastrophic failure. A working capital loan can be the emergency fund you need.
5 types of working capital loans
Here are five potential 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 receivables are most often the collateral in the borrowing base.
Each month you submit an AR aging report, and the bank unlocks 75%-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. That’s because the bank needs a margin of safety in case some of your customers never pay.
The intent of the line is for you to pay it down when you are paid by the ARs. This is called revolving the line. The cycle is for you to make a sale, borrow from the line to fulfill the sale, and then pay the line down when you receive cash.
If you borrow and never make a payment, the bank will consider your line evergreen. Eventually, the bank will require you to make principal payments on the line to pay it down.
Many revolving lines have annual renewals to let the bank refresh its underwriting (and collect a fee) and give you an opportunity to increase or decrease the line amount. If you can find a bank willing to forgo annual renewals, take the deal.
2. Unsecured line of credit
Unsecured working capital lines of credit are slowly going the way of the dodo bird. Years ago you could get a “signature loan,” so-called because all it took to get the loan was your signature on the line guaranteeing it.
Today, every bank has multiple regulators looking into its balance sheet, and any uncollateralized loan is over-scrutinized. You may be able to pull off a super small loan secured by office assets (desks, copy machines, microwaves covered in years of exploding ravioli). Otherwise, think about using a U.S. Small Business Administration (SBA) loan or corporate credit cards.
3. SBA term loan
Have you ever seen The Big Short? SBA working capital loans are the new mortgages in 2005. Big banks originate government-guaranteed working capital loans up to $350,000 and sell them off on a secondary market.
The loans have 10-year terms and a variable interest rate. The big banks go by the philosophy that the more they generate, the less impact defaults will have on the whole portfolio.
This may be a bad long-term strategy for the banks, but it could work out nicely for you. If you need to make a working capital investment in tenant improvements or start up a new advertising campaign, think about getting an SBA working capital loan. The payments will be high, so use the money smartly to increase operating cash flow to cover them.
4. SBA revolving loan
The SBA also has a revolving line of credit product. It’s governed by a borrowing base and has annual renewals. The line is typically structured to have a five-year draw period followed by a five-year term-out.
This means you have five years to use the line as you would any revolving line of credit, and once that term is up, you make payments over the next five years to pay off the balance. At that point, you should be able to replace the SBA line with a conventional revolving line. Generally, conventional lines are better because they have lower fees; SBA loans are for businesses that can’t get a conventional loan.
5. Credit cards
Don’t rely on credit cards for your working capital. Credit cards are good for one thing: reward points. Unless you legitimately can’t get any other loan, pay off credit card balances each month and just use them for 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 is taking weeks and weeks, don’t be afraid to jump ship.
1. Gather documents
As with any loan, you’ll need to provide a ton of information to get the loan. Here’s 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 income sources)
- Loan application allowing a personal credit report to be pulled
- Management resume
2. Approach your bank
Working capital loans should be the backbone of your relationship with the bank. Walk into your normal branch and ask about your options. If they aren’t good, you may want to look into taking your relationship to a new bank. If the relationship is generally good, but you wouldn’t qualify for a loan, ask your banker for recommendations. Most bankers keep contacts who will do loans their bank won’t.
Most banks have a streamlined working capital loan process. Many approve loans under $500,000 to $750,000 with an algorithm. Keep this in mind. If the application and decision process is taking forever, you can almost certainly do better somewhere else.
Das working kapital
Cash is the oil that greases the engine that is a business, and working capital loans make it a lot easier to keep that cash flowing in hard times. The key is to not get addicted to the loans. Whenever possible, stick to using internal business capital and cash flow because all leverage comes with a cost.