The working capital of your company is its backbone. Working capital is the money that your business uses for daily operations and to cover operational expenses. Working capital includes everything from equipment costs to employee salaries.
Lack of working capital can create cash flow problems within a company. There are a few funding options that can help you. Working capital loans are a group of funding options.
- Short-Term Business Loans
- Lines of Credit
- Account Receivables Loans
- Small Business Administration Loans
You must understand the requirements for loan qualification before can apply for a working capital loan.
What are your needs for a loan to cover working capital?
You must first determine your working capital needs. If you are unsure if you should apply, ask yourself these questions.
How much money do you need to borrow?
Calculate the working capital ratio to determine how much working capital your business requires.
Working Capital Ratio = Current Assets/ Current Liabilities
If your working capital ratio is between 1.5 and 2 you will have enough cash to run your business smoothly. If this ratio is below 1.5 it means that you are lacking in working capital. Calculate the amount of loan you will need by adding up your “Current Assets”.
How would you like to access your funds?
Two ways are available for a lender to disburse funding for working capital:
- Lump Sum: A transfer that includes all the funds you have requested.
- Revolving line of Credit: You can get a credit line that you can use whenever you need to.
Which of these options is best for your business? If you are experiencing temporary cash flow problems, a lump sum might be the best option. A line of credit is better if you have frequent financial issues.
What is your maximum repayment term?
Each working capital loan has an interest rate, as well as a payment period. The interest rate and the repayment period can both influence your decision. Many working capital loans, for example, allow you to pay weekly, biweekly or monthly. Monthly payments are bigger, but less frequent. Weekly payments may be more convenient for your business, but they are also more frequent. How much you pay back depends on the interest rate of your loan.
The repayments for account receivables loans and merchant cash advances (MCAs) are different. MCA loans are repaid through your weekly or daily credit card transactions. Your invoices are collateralized with accounts receivables loans. You repay the loan using this money once your customers have paid their invoices.
Do you want to provide collateral for the loan?
A collateral is an item or asset of value that you pledge to secure a loan. Your lender will collect the collateral item if you fail to repay your loan.
Most traditional lenders will require collateral to access working capital loans. You should ask yourself if this asset is worth losing and if it’s worth offering as collateral.
What requirements do lenders have to meet in order to qualify for a working capital loan?
The requirements for working capital loans vary depending on the lender. Most lenders have some criteria that you must meet in order to get a loan. These are the factors that lenders consider when approving funding for working capital.
Scores for Personal and Business Credit
Your loan eligibility can be affected by both your personal and business credit score. Your lender is likely to check both scores at the major U.S. bureaus of credit, including Experian TransUnion and Equifax.
Your business credit score and your personal credit rating both include information on your credit history, tax judgments and payment record. It is used by lenders to assess the financial reliability of your business.
Age of the Business
Lenders consider stability when determining the amount you can borrow. The lender will be less willing to lend if your company has a short history. Start-ups can find it hard to get working capital financing. In contrast, older companies often have easier access to financing for working capital.
Before offering you a loan, most lenders will want to see that your business has been in operation for at least six consecutive months.
Profits & Revenues
If you want to get a loan, lenders will check the profit of your business. You’ll be less likely to receive a loan if the amount of the loan you request exceeds the profit figure. This is all about stability. Your lender will want to know that you can repay the loan.
Debt to Income Ratio
The debt-to-income ratio (DTI) is a measurement of your credit history. This ratio allows a lender, using the formula below, to compare your monthly income with your current debt payments.
DTI = Monthly debt payments / Gross monthly income
Imagine, for example, that you have a $5,000 income and a $2,000 debt repayment. This equation gives the following answer:
2000 / 5000 = 0.4
Your DTI is therefore 40%.
Lenders are looking for a low percentage.
The ratio of debt service to total income is calculated as follows:
Your debt service coverage (DSCR), is used by lenders to determine if the current cash flow of your business can meet its debt obligations. It’s similar to DTI in that it measures debt-handling capability. The formula lenders use for DSCR is:
DSCR = Net operating income / Total debt service
If you have a business with an operating income of $500,000 and a debt of $200,000, the result is:
500,000 / 200,000 = 2.5
If your DSCR is close to 1 or lower, you may have difficulty repaying a working capital loan.
Collaterals and Personal Guarantee
You can get a higher loan amount and lower interest rates by offering collateral or a personal guarantee. Low credit score holders can also take advantage of collateral-based loans. You assume a higher risk of defaulting if you do not pay. Loan applications can be more complex when collateral is required.
If you have a bad credit rating, a lender might ask for collateral. It may be required for companies with low DSCRs.
Business Plan
The Business Growth Plan is the roadmap of your business for the future. The plan tells the lender who you are, what you do and how you make money. It also includes your future projections. Business plans are often checked by lenders to find out the following:
- Who do you serve?
- How to generate revenue
- Your market
- What’s your management team made up of?
- Your financial projections
- You can offer collateral
Bank Statements and other Documents
When you apply for a mortgage, most lenders will require financial documents. These documents include tax returns, and bank statements. These documents are a record of the financial history of your business. These documents may be requested by your lender from all of the major shareholders.
A lender may request additional documents in addition to these two:
- Proof of collateral
- Debt declarations
- Proof of Business Ownership
- Employee Identification Numbers (EINs).
FAQs
Which is better: Working capital loan or line of credit?
Both options provide short-term solutions for cash flow issues. Lines of credit are a good option for companies who need a constant pool of money to draw from when necessary. Working capital loans are usually fixed-rate and offer lump sum funding.
How do you determine the amount of a working capital loan?
Working capital financing is determined by several factors. They may also check the finances of your shareholders. They will also examine what your company does and how much it earns.
