A Business Owner’s Guide to Understanding Working Capital Loan Interest Rates

In this article, you’ll learn:

  • What working capital is
  • Ideal amount of working capital for your small business
  • Types of working capital loans, and apples-to-apples comparisons of their interest rates

As a small business owner, it’s important to be able to cover short-term debts and expenses – and since your cash flow isn’t 100% predictable, you need to have a cushion to withstand unexpected events. There’s a metric that approximates this cushion: it’s called working capital.

What is Working Capital?

Your working capital is your current assets minus your current liabilities. Your current assets are any assets on your balance sheet that are expected to be sold or used over the next year – they include cash, cash equivalents, accounts receivable, prepaid expenses, and inventory. Your current liabilities are liabilities that are due over the next year – they include accounts payable, notes payable, taxes payable, and dividends.

You have positive working capital if your current assets are greater than your current liabilities, and negative working capital if your current assets are less than your current liabilities.

What is the Ideal Amount of Working Capital for Your Small Business?

There is no single ideal amount of working capital for a small business – it depends on a few variables:

  • What is your type of business? Do you have a seasonal business that is growing rapidly? Or do you have a mature business with steady quarter-to-quarter revenue? The former is going to require more working capital to provide a cushion during quarters with low sales and fund long-term growth.
  • When do you bill customers? Let’s say you have a services business, and it takes two months to render services to the average customer. Your working capital needs are going to be heavily impacted by when you bill your customers (half upfront and half upon completion, all upfront, all upon completion, etc.).
  • What is your projected operating cash flow? A startup that is expecting to triple its operating cash flow over the next year may be able to withstand slightly negative working capital. But an established business that is expecting operating cash flow to be flat over the next year shouldn’t have negative working capital, in most cases.
  • How much do you have in current liabilities? For a company with $20,000 in current liabilities, $40,000 in working capital is likely to provide a nice cushion for unexpected events. But $40,000 in working capital may not be enough for a company with $1 million in current liabilities. The first company has 3x as many current assets as current liabilities, while the second company has 4% more current assets than current liabilities. It’s all relative.

As you can tell, there is a lot that impacts the ideal amount of working capital. But working capital ratio (current assets/current liabilities) is an excellent starting point for the ideal amount of working capital, as it eliminates the “how much in current liabilities” variable. According to Investopedia, most analysts consider the ideal working capital ratio to be between 1.5 and 2. You can adjust this number upwards or downwards – by a bit – depending on your answers to the other three questions.

Types of Working Capital Loans

There are several working capital financing options for small business owners. With some types of working capital loans, the payment is based on an explicitly stated interest rate. But other funding options calculate the payment based on fees or a factor rate – while there isn’t an explicitly stated interest rate, it’s possible to settle on an equivalent interest rate.

In this section, you’ll get apples-to-apples comparisons of working capital financing options – seeing how the explicit interest rates stack up against the equivalent interest rates.

So, without further ado, here are some of the best working capital loans:

SBA 7(a) Loan

The U.S. Small Business Administration (SBA) 7(a) loan program provides small business owners with a maximum loan amount of $5 million. The money can be used for a variety of purposes, including working capital needs. The SBA guarantees the majority of the loan, reducing the risk of the lender – this allows the lender to offer a lower interest rate to borrowers. This rate varies depending on the loan amount and whether it is a fixed or variable rate loan – here is some information on the rates.

The low interest rate available via an SBA loan makes it an attractive option for small business owners, but strict eligibility requirements and a lengthy loan application process make it tough to use an SBA loan for short-term working capital needs in many cases.

Term Loan

A term loan provides the borrower with upfront cash to be repaid on a set schedule at a variable or fixed interest rate. The specifics of a term loan vary depending on the lender. Here’s an overview of what you could expect with Biz2Credit:

  • Loan amount between $25,000 and $500,000.
  • Payment plan ranging from 12 to 36 months.
  • Funding in as little as a few days.
  • Most customers get started with $250k in annual revenue, 660+ credit score, and at least 18 months in business.
  • Rates start at 7.99%.

With a traditional bank loan, you may be able to get a loan with attractive terms. The difference, however, is you are likely going to have to wait much longer to get an approval or denial decision.

Business Credit Card

A business credit card works similarly to a personal credit card, with one key difference: it’s connected to your business instead of your personal life. Since working capital needs are often short-term and unpredictable, a business credit card is a great way to satisfy those needs in many cases.

While many business credit cards have double-digit interest rates, you may be able to find a credit card with a 0% APR introductory period for between 6 and 18 months. Let’s say you have an upcoming period where your working capital ratio is going to be on the lower end… but you think there’s only a 25% chance you’re going to need more money to satisfy short-term obligations. In this example, a business credit card with a 0% APR introductory period would be a great option.

Business Line of Credit

A business line of credit is like a combination of a business loan and a business credit card, as you can borrow what you need and you only pay interest on the amounts borrowed.

With many online lenders, you need a 580+ credit score, 12 months in business, and $10,000 in average monthly revenue to qualify for a business line of credit. So, the bar is not too high for a business line of credit.

The average interest rate is between 7% and 25%. In addition, the interest rate is variable in many cases – so you may not know your interest rate ahead of time. The good news is that you’re under no obligation to use a business line of credit if the interest rate is higher than you expected.

Merchant Cash Advance

A merchant cash advance (MCA)  is a small business financing option that provides small business owners with a lump sum payment to be repaid through a percentage of future sales. With a merchant cash advance, the amount to be repaid is based on a factor rate, not an interest rate. The factor rate, which is typically somewhere between 1.2 and 1.5, is multiplied by the amount borrowed – and that number is the total amount to be repaid. So, if you borrow $100,000 with a factor rate of 1.3, the total amount to be repaid is $130,000.

The repayment period for a merchant cash advance is often a year or less, so the equivalent interest rate can be high double-digits – or even low triple-digits. The good news is that a merchant cash advance is attainable for small business owners without high credit scores, as a 525-550 credit score is often sufficient.

Invoice Financing

With invoice financing, you can borrow money against your outstanding accounts receivables, potentially getting 80-90% of the value of your unpaid invoices upfront. The invoice financing company typically charges a flat percentage (1-5%) of the invoice value in exchange for providing the money upfront. This doesn’t sound like much, but if you get charged 2% of the invoice value and it only takes 2 weeks for the client to pay the invoice, the equivalent annualized interest rate is very high.

You may be able to qualify for invoice financing if you have a startup or bad credit, and if you use it to satisfy very short-term working capital needs once in a blue moon, the high “interest” won’t matter much in the grand scheme of things.

Invoice Factoring

Invoice factoring provides small business owners with a lump sum of cash in exchange for their outstanding invoices. With invoice factoring, you sell the invoices to the company – you get the value of the invoices minus a factoring fee (typically between 1-5%). In many cases, the company pays you 85% of the amount upfront and pays you the rest of the money (minus fees) after the invoice is collected.

It’s not too hard to qualify for invoice factoring, but as with the merchant cash advance and invoice financing, the “interest” is usually on the higher end.  

The Bottom Line

Your working capital needs are likely to be short-term in nature, so it’s easy to overlook the interest rate being paid on borrowed funds. But the interest rate is sometimes really high (e.g., merchant cash advance, invoice financing, and invoice factoring) or you may have to repeatedly secure working capital financing – so the funds could ultimately cost a lot of money if you aren’t careful.

In any case, you don’t want to wait long to get working capital funding. With Biz2Credit, you can get funded as fast as 72 hours.

Navneet Kalra, the President of Perfume Store Inc., wanted to secure inventory financing so he could satisfy sky-high holiday season demand. With Biz2Credit, he got an offer by the next day, and said, “I’ll give Biz2Credit a 10 out of 10. The whole team I worked with did an excellent job – they understood my business and everyone from my case manager to the underwriters were very friendly and communicative.”

Learn more about how Biz2Credit can help your small business get working capital financing.

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