As a small business owner, you may be considering a working capital line of credit to help with cash flow. This guide will provide everything you need to know about how these lines of credit work and what to consider before applying. The right information can help you make the best borrowing decision, ensuring adequate cash flow to cover planned and unplanned business expenses.
What Is Working Capital?
The money you have available to pay for your short-term business expenses is your working capital. Also referred to as "net working capital" (NWC), you get to this number by subtracting your liabilities (e.g., expenses) from your assets (e.g., equity).
- Assets include things like inventory, equipment, cash on hand, and owned real estate.
- Liabilities can include accounts payable, credit card balances, and short-term loans.
Your working capital is any equity that remains after you pay your short-term debts and expenses. It's important to have positive working capital because it shows that your business can cover its day-to-day expenses and have money left over for growth. A positive working capital is also something you can borrow against.
What Is a Working Capital Line of Credit?
A working capital line of credit is a loan that provides your small business with access to funds as needed. This type of financing is helpful if you experience irregular cash flow or need short-term financing for inventory or other expenses. Working capital loans are tremendously helpful to small businesses. They can provide a safety net to cover gaps in cash availability.
A working capital business line of credit works like a credit card or traditional loan in that you're approved for a certain amount of funds. You access the credit when you need it and pay the balance monthly, just like with a credit card or standard loan.
For example, let's say your small business is approved for a $50,000 working capital line of credit and you use a partial amount — say, $5,000 — to cover payroll and inventory for two months. You only need to pay back the interest on the amount you borrowed, versus the full $50,000 as you would with a long-term loan.
This type of financing is helpful if you don't want to take on more debt than necessary.
Advantages of a Working Capital Line of Credit
The advantages of a working capital line of credit are compelling, particularly for small businesses that may not have the credit history or collateral for a long-term bank loan. Working capital lines offer flexibility, financial security, and a stress-free way to help you manage cash flow.
Here are some key benefits of working capital loans:
- Flexibility: A working capital line of credit has no set repayment schedule or terms. This makes it flexible and convenient, since you're not locked into a specific time frame for using your credit or repaying the full amount of the loan. It can provide peace of mind if you're dealing with irregular cash flow, need short-term financing for inventory, or have to cover an unplanned expense.
- Quick approval and access: Because a working capital line of credit is based on your business’s existing assets, such as inventory or receivables, it can be approved quickly — sometimes in as little as 48 hours. Once approved, you have immediate access to funds, ensuring you're covered for last-minute expenses (or sudden opportunities).
- Revolving credit with no time limit: A working credit loan is based on a line of credit, meaning you can access funds as needed up to your credit limit. Once you repay the borrowed amount, the funds will become available again. It basically gives you indefinite access to extra funds on an as-needed basis.
Disadvantages of a Working Capital Line of Credit
There are several points to consider before applying for a working capital line of credit, such as your business’s needs and financial situation. This type of financing isn't right for every business, so it’s important to do your research and understand the pros and cons before deciding. Potential disadvantages include:
- High interest rates: Interest rates on working capital lines of credit can be higher than other types of loans because they're based on your business's creditworthiness. If you have poor credit or a limited credit history, you may be charged a higher rate.
- The expense: Like any loan, there are costs associated with taking out and maintaining a working capital line of credit. In addition to interest, borrowers often need to pay underwriting, closing, and service fees.
- The impact on credit: Because a working capital line of credit is a revolving loan, it can have a negative impact on your business's credit score if you max out your credit limit or make late payments.
Working Capital Line of Credit vs. Business Line of Credit
There's often confusion between working capital lines of credit and business lines of credit. While both can provide much-needed financing for small businesses, there are some key differences to be aware of.
A business line of credit is a loan that allows you to borrow up to a certain amount of money (usually based on your annual revenue) which you can access as needed. Withdrawing funds doesn't require approval from the bank. This makes it easier to access the funds when you need them.
As with a business line of credit, a working capital line of credit is specifically for businesses that need financing to cover day-to-day operating expenses, such as inventory, payroll, or rent. The main difference is that it's typically easier for businesses to qualify for a working capital line of credit versus a business line of credit. Interest rates can be lower for this type of loan since it's based on your business equity. Approval and fund withdrawal move faster too, with a shorter wait time from application to approval.
How to Use a Working Capital Line of Credit
Here are some examples of how you can use your working capital line of credit:
- Make pre-season purchases for seasonal businesses: Take advantage of early discounts and ensure you have the inventory you need when business picks up.
- Fulfill large, unexpected orders: Cover the cost of raw materials or goods from suppliers without dipping into your operating funds or requesting advances from suppliers.
- Cover the necessities: Pay rent, payroll, and utilities when you’re facing a cash flow shortage.
- Address emergency repair costs: Fix a broken HVAC system or repair damage caused by a natural disaster without putting other expenses on hold.
- Get peace of mind: You’ll have a back-up working capital source in case of slow months or unforeseen expenses.
Terms You Can Expect on a Working Capital Line of Credit
The terms of a working capital line of credit vary by lender. The amount you can withdraw and how fast you can withdraw it varies as well. Once approved, you may receive funding in 1-2 days.
Interest rates on working capital lines of credit are usually variable, which means they can go up or down over time. However, some lenders may offer a fixed rate for a promotional period (e.g., the first 6 or 12 months).
The amount you can borrow will depend on the lender, but typically ranges from $1,000 to as much as $5 million. And, because it's a revolving loan, you can continue to access funds if you don't exceed your credit limit. It's important to communicate with the lender and make sure you understand the fees and rates you're responsible for paying.
Repayment terms vary depending on the lender, but typically range from six months to five years. Loan renewal is contingent upon meeting certain criteria, such as maintaining a good credit score and making regular, on-time payments.
Keep in mind that a variable interest rate can increase over time. Thus, it can be challenging to budget for your loan repayments. Also, some lenders require collateral to secure the loan — real estate, a personal line of credit, etc. — meaning your business or personal assets are at risk if you can’t repay your loan.
One of the most important things you can do when committing to a working capital line of credit, is to understand the terms. Make sure you know your responsibilities and that you’re comfortable with the loan’s terms and requirements.
Grow Your Business With Aion Capital
Now that you know how working capital lines of credit work, you can decide if this type of financing is right for your business. Aion offers credit lines ranging from $10,000 to $5 million with transparent pricing, and same-day funding options.
You can apply for capital in minutes and receive a proposal within 24 hours. Get started creating an Aion account today.