Working Capital Loans: The Definitive Guide (2020 Update)

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Every small business has experienced how important it is to have sufficient working capital on hand. Working capital loans are monies a business needs to operate and the cash your company has to cover costs.

The operating costs include buying inventory, paying employees and maintaining your building. If your capital is spread thin, it’s time for a working capital loan.

In this article, you will learn where to get a small business loan and how it will help your business grow.

Working Capital Loans vs Traditional Business Loans

A traditional business loan is a fixed amount of money to buy something specific, usually a business asset like a car or a new building, or even a new business.

Business loans are for a fixed amount of money, and the asset usually secures them. For example, a business loan to buy a building uses the building as collateral in case the loan isn’t paid.

A working capital loan is usually not secured; it doesn’t have any collateral behind it. A working capital loan may also be a line of credit, that you can take from as you need it.

How working capital is used in a business 

Working capital is a liquidity (cash)concept. A company might show a “profit,” but if it cannot maintain a favourable cash position (that is, having money in the bank to pay bills each month), the business cannot continue to operate.

Sometimes a company does not have adequate cash on hand or asset liquidity to cover day-to-day operational expenses and, thus, will secure a loan for this purpose.

Companies that have high seasonality or cyclical sales usually rely on working capital loans to help with periods of reduced business activity.

Also Read12 most profitable business in Kenya

How to calculate working capital loans

The calculation is simple: subtract current liabilities from current assets. Existing assets are cash and assets you can convert into cash within a year.

These assets comprise accounts receivable, inventory and short term investments.

Current liabilities are short term debts or accounts that you need to settle within a year.

These include accounts payable, overdrafts, sales tax, payroll expenses and wages.

You should aim to have more current assets than liabilities or positive working capital. If existing assets don’t exceed current liabilities, you have a deficit. You may have problems paying creditors, with the worst-case scenario being bankruptcy.

Even if you have a profitable business, you can struggle. Cash may be tied up in assets such as inventory, and an inability to convert them into cash signals weak liquidity.

But even after calculating your working capital, how do you know what amount is suitable? Do you have enough? Do you have too much?

Enter the working capital ratio.

Also Read: How to invest 100K in Kenya

When do you need working capital loans?

Whether you’re a new, growing, or established business, working capital, is crucial. It’s critical for day-to-day operations, payroll and paying creditors.

It’s even more critical when your company’s about to take a big step. For example, if you’re a business starting a large project that you only get paid for upon completion, you need capital to keep you going during that period.

And if you don’t have it, you’ll have to find it, or risk project failure.

You can get a bank loan, but the interest that accrues is often excessive and will affect your profitability. The solution is to find funding elsewhere.

Where to get working capital loans?

 1. Invoice factoring

A factoring company (also called a “factor”) purchases your business’s outstanding invoices for a percentage of their face value — typically about 70 per cent to 85 per cent.

The factor then takes over collecting your invoices; when the element receives, they give you the rest of the invoice’s face value, minus their fees.

While it is a quick way to get money, you won’t get the full amount you’re owed. And since the factor takes over your collections, this can confuse your customers.

Also Read: Understanding asset financing in Kenya

2. Merchant cash advance financing

Does your business make a lot of credit card sales? The merchant cash advance (MCA) financing might work for you.

With this financing option, you take a cash advance against your business’s future credit card sales.

The lender collects a percentage of your daily credit card sales until the advance and fees are paid off.

No collateral is necessary, and on days when your credit card sales are low, your payment will be, too. However, fees for merchant cash advances can add up quickly.

3. A business line of credit

If you can qualify for one, a business line of credit offers lots of advantages as a source of working capital.

It’s unsecured, which means you don’t have to put up any collateral. What’s more, you don’t have to repay any money until you draw on the line of credit.

In other words, if you get a line of credit for Ksh. 2.5M in January and draw Ksh. 1.5M to make payroll in June, you won’t have to start making payments until July.

As you pay back what you borrowed, the available amount of credit increases until it’s back where you started.

There’s got to be a catch. There is: Your business will need a track record of success and an excellent credit score to qualify.

4. Use a Credit Card

Using a credit card to fund your business is some serious risky business.

Fall behind on your payment, and your credit score gets whacked. Pay just the minimum each month, and you could create a hole you’ll never get out of.

However, used responsibly, a credit card can get you out of the occasional jam and even extend your accounts payable period to shore up your cash flow.

5. Get a microloan

The lack of credit history, collateral or the inability to secure a loan through a bank doesn’t mean no one will lend to you.

One option would be to apply for a microloan, a small business loan ranging from Ksh. 50,000 to Ksh. 3500,000.

Microloans are often so small that commercial banks can’t be bothered lending the funds.

Instead of a bank, you need to turn to microlenders like SACCOS that works differently than banks.

Microlenders offer smaller loan sizes, usually require less documentation than banks, and often apply more flexible underwriting criteria

Also Read: Top mistakes in applying for a small business working capital loan

6. Attract an Angel Investor

When pitching an angel investor, all the old rules still apply: be succinct, avoid jargon, have an exit strategy.

But the economic turmoil of the last few years has made a complicated game even trickier. Here are some tips to win over angel interest:

  • Add experience: Seeing some grey hair on your management team will help ease investors’ fears about your company’s ability to deal with a tough economy. Even an unpaid, but highly experienced adviser could add to your credibility.
  • Don’t be a trend-follower: Did you start your company because you are genuinely passionate about your idea or because you want to cash in on the latest trend? Angels can spot the difference and won’t give much attention to those whose companies are essentially get-rich-quick schemes.
  • Know your stuff: You’ll need market assessments, competitive analysis and reliable marketing and sales plans if you expect to get anywhere with an angel. Even young companies need to demonstrate expert knowledge of the market they are about to enter as well as the discipline to follow through with their game plan.
  • Keep in touch: An angel may not be interested in your business right away, especially if you don’t have a track record as a successful entrepreneur. To combat that, you should formulate a way to keep them in the loop on significant developments, like a substantial sale.

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