If you needed a short-term business loan to cover your regular operating expenses, you would need what is known as a working capital loan. Whether you’re looking for funds to cover rent, wages, or inventory purchases, a working capital loan might be the solution to help you get your finances back on track.
You have other financing options, but it’s important to evaluate for the right fit, particularly if you want to preserve equity. With over 50% of a founder’s equity often lost in just the first several rounds of funding, founders have a delicate balance to navigate as they strive to fund growth, maintain equity, and bring in investment.
Let’s dive in to uncover what a working capital loan is, how to assess your capital needs, which mistakes to avoid, and how 5th Line can help you refine your financial strategies.
What is a Working Capital Loan?
In short, working capital is the difference between a company's current assets and its current liabilities. Current assets are resources that are expected to be converted into cash or used up within one year, such as accounts receivable and inventory. Current liabilities are obligations that are due within one year, such as accounts payable, short-term loans, and accrued expenses.
Once calculated, your working capital represents the amount of liquid assets available to your company to cover its short-term obligations and operational expenses. When your company doesn’t have enough capital to cover those expenses, a working capital loan can keep your team running and preparing for growth.
How to calculate working capital
To understand how much funding you need, you’ll first have to determine your current working capital. The calculation involves subtracting current liabilities from current assets, leaving you with the amount of money available to meet current business expenses:
Working Capital = Current Assets − Current Liabilities
For example, if a company has $100,000 in current assets and $60,000 in current liabilities:
Working Capital = $100,000 − $60,000 = $40,000
When a company's current assets are less than its current liabilities, it's considered to have negative working capital. Conversely, positive working capital means the company has enough current assets to cover its short-term obligations and support future investments and expansion.
It’s also important to note that while high positive working capital can seem like a strong sign, it might not be. If this applies to your company, consider whether you could take advantage of more debt opportunities, invest surplus cash, or reduce inventory.
Another valuable metric is your working capital ratio. This is a measurement of your short-term financial health, calculated as follows:
Working Capital Ratio = Current Assets / Current Liabilities
If a company holds $1 million in current assets and owes $500,000 in current liabilities, their working capital ratio stands at 2:1. This ratio is typically viewed as healthy for most industries.
Working capital loan types
If your company is struggling to come up with the cash required to cover day-to-day operations, a working capital loan might be right for you. This loan type is designed to be a temporary solution that offers quicker access to funds along with shorter repayment periods.
Unlike loans geared toward longer-term investments, such as CapEx facilities, working capital loans operate on a shorter timeline to address immediate financial needs. You can get working capital loans from banks, credit unions, or online lenders.
Though there are loans explicitly designated for working capital purposes, you can also turn to some other types of loans with similar results:
- Term loans: A traditional loan with a lump sum disbursement and fixed repayment schedule.
- SBA loans: This is a good option for companies in need of larger loan limits with lower eligibility requirements.
- Business lines of credit: A line of credit can help your company build up your credit score and allows you to borrow as you go, avoiding the risks of taking on more debt than you need.
Understanding Your Working Capital Needs
A clear understanding of your capital needs is vital for effective working capital management. Each business has unique factors such as operating cycles, cash flow patterns, and financial requirements that influence its working capital needs. Industry dynamics, seasonality, growth projections, and market conditions all impact these needs.
Here are a few use cases for working capital loans:
- Bridging the gap between slow and busy seasons
- Taking advantage of bulk order discounts from suppliers
- Financing a short-term project
- Avoiding a cash crunch
Preparing to apply
If you’re interested in a working capital loan to help your company meet its immediate cash flow needs, these steps can help you get ready to apply:
- Calculate the amount you need by totaling the operating expenses covered by the loan.
- Consider the factors that lenders will use to evaluate your company. This means staying on top of your credit score and annual revenue along with any lender-specific requirements.
- Send in your financial statements and other supporting documentation to lenders. A team like 5th Line is well equipped to help you find flexible, reliable lenders.
- Compare loan options to get the best deal based on your financial goals.
Working Capital Loan Mistakes to Avoid
Securing a working capital loan from a reliable lending partner is essential for business success, so there are several common mistakes companies should avoid:
Overlooking accounts receivable and payable: Inefficient accounts receivable management can impact how you present your working capital and cash flow to lenders. To optimize, implement effective credit policies, monitor payment trends, and follow up on overdue invoices.
Relying too heavily on one type of financing: While short-term financing options such as lines of credit or overdraft facilities provide temporary liquidity support, relying too heavily on these sources can increase financial risk and interest expenses. 5th Line can guide you as you strike a balance between short-term financing and long-term capital investments to maintain a healthy working capital position.
Confusing short-term working capital needs and long-term needs: If you need to purchase machinery, equipment, real estate, or other more permanent assets, you may be better served by another type of financing. This will keep your working capital loan funding available for more current financial demands.
How Can 5th Line Advisors Increase Your Working Capital?
Wondering how 5th Line can help you secure a working capital loan? We know that lenders evaluate a range of factors when assessing your application, including the health of your balance sheet, working capital ratio, and annual revenue.
After working with many growth-stage companies, our advisors know what it takes to find favorable terms and deals. Here are a few things we can help you with:
- Turning to our network of lenders and securing the best possible loan amounts, interest rates, and repayment terms
- Freeing up capital tied up in accounts receivable, inventory, or contract fulfillment
- Financing the purchase of your inventory for sale to avoid tying up working capital or equity funds
- Boosting liquidity while you wait for customer payments
- Financing the materials and labor associated with order fulfillment to meet customer demand
At 5th Line, we enable growing companies to obtain funding through favorable deals. We leverage our network and expertise to offer companies in need of working capital a range of funding options to explore, and we can advise you on the most strategic approaches for specific deals and contracts.
Final Thoughts
Understanding your company's financial health includes working capital—a concise summary of your current financial status. By conducting a capital needs assessment, understanding how to prepare for a loan, and learning which pitfalls to avoid, you can work with 5th Line to secure new lines of credit and repurpose existing capital effectively.
Whether you’re already actively looking for additional working capital or are poised to enter the growth stage, we can provide financial support tailored to your company. If you want to learn more about what we do, get in touch today.