Everything you need to know about working capital loans for SMEs

A working capital loan can provide a vital cash injection when you're struggling with short-term operational expenses. This might include payroll or rent for your business premises.

Here's what you need to know.

Key takeaways

• A working capital loan is a short- to medium-term financing option that helps businesses cover day-to-day operational expenses, like payroll or bills.

• These loans can be unsecured, relying on the business owner’s personal credit history, or secured by an asset, such as property or equipment, to reduce risk for the lender.

• Working capital loans are especially useful for businesses with fluctuating sales cycles and are often easy to set up when quick funding is needed.

What is a working capital loan?

Working capital loans are business loans you can use to cover day-to-day costs such as payroll, rent and debt payments. As such, they are generally short- or medium-term loans lasting from a few weeks to up to two years.

The amount you can borrow via a working capital loan depends on:

• The size and financial situation of your business

• The type of loan you choose

Other requirements relate to the type of loan you choose.

• Unsecured working capital loans often depend on the business owner’s personal credit score and may involve providing a personal guarantee

• Secured working capital loans hinge on the value of the assets you put up as security, which affects both the size of the loan and the interest rate you pay

How do working capital loans work?

As with most types of business loans, applying for a working capital loan involves providing details of your company’s finances so lenders can evaluate your application.  

They base their decision on factors such as your business credit score, indebtedness and operational history.

If the lender approves your application for a working capital loan, the agreed amount — known as the principal — is paid into your business bank account and you can start to use it.

Common uses of working capital loan finance include:

• Paying suppliers

• Covering employee wages

• Buying necessary stock

• Paying marketing and advertising costs

Bear in mind that you must have enough cash available to repay the loan — along with any interest and charges — according to the terms of the loan agreement. This is usually done via a series of regular repayments. 

Is a working capital loan right for my business?

Working capital loans can help companies with cyclical sales survive slow periods. They also provide a financial lifeline in case of unexpected expenses, such as when a major client goes bankrupt or business drops unexpectedly.

Some businesses also use working capital loans to improve cash flow management. However, the interest on loans of this kind can be higher than the average rates you might pay for another form of business credit. 

Advantages of working capital loans

The main advantages of working capital loans are:

• They offer quick access to cash when you need it

• They’re a form of debt financing that allows you to maintain full control of your business

• They can cover any expenses – you don’t have to state the purpose of the loan

• They are available as both unsecured and secured loans, according to your requirements

• They are short-term agreements that don’t generally involve lengthy tie-ins

Disadvantages of working capital loans

The main disadvantages of working capital loans are:

• Working capital loans are for companies struggling with cash flow, so interest rates are often higher than on other forms of borrowing

• You need good business and personal credit scores to get an unsecured working capital loan, and they can impact your personal credit file if you miss a payment

• You must still pay back a working capital loan, even if your business goes bust

• Your assets are at risk if you default on a secured working capital loan

• These loans are generally short-term arrangements with relatively high repayments

Alternative types of working capital finance for SMEs

Working capital loans are just one option if you need to borrow money to keep your business afloat in the short term.

Other popular forms of business credit include:

• Business credit cards: An easy way to access working capital, business credit cards may offer rewards but can prove an expensive way to borrow longer term. The amount you can borrow this way depends on the limit you’re given.

• Business overdrafts: Linked to business bank accounts, overdrafts provide quick access to extra cash when you need it. Again, the interest rates and charges are generally high, and you can only borrow up to your overdraft limit.

• Invoice finance: Invoice finance allows companies to access money they’re owed by customers ahead of time and is another way to access working capital quickly when you need it. The lender uses the unpaid invoices as security for the loan, which involves factoring or invoice discounting. You can find out more with our handy guide to invoice finance.

• Asset finance: This type of finance covers the cost of buying or hiring assets, such as equipment, vehicles or machinery, against which it is secured. It can help with cash flow management by enabling businesses to acquire assets without using up all their cash reserves. Another plus is that it can be easier to obtain asset finance than a traditional business loan. Check out our guide to asset finance for more information.

• Merchant cash advances: These are upfront payments you get in exchange for a percentage of your future credit and debit card receipts. Suitable for businesses that take a lot of card payments, they are a highly accessible — if expensive — form of business finance.