What is a working capital line of credit and how does it work?

When you’re running a small business, finding the necessary capital for everyday expenses can be difficult. For example, many businesses experience seasonal income cycles. Some times of the year may be high cash flow periods while other months are slower and bring in little or no income. This is a scenario where a working capital line of credit is useful. These financial tools help business owners cover every day expenses in times where cash is needed to cover expenses during tough times. Here is everything you need to know.

What is a working capital line of credit?

In basic terms, working capital line of credit is a revolving loan that businesses can use for everyday cash needs such as maintaining inventory or covering payroll. They can be used for short-term periods when you don’t have much cash inflow but you expect to get more cash in the near future.

Working capital lines of credit are particularly well-suited for businesses with seasonal cash flow cycles. These may include agricultural businesses, Retailers and restaurants in seasonal tourist areas or retailers selling holiday products.

How does a working capital line of credit work?

A working capital line of credit can be used as a flexible financing option to help businesses cover short-term operational expenses such as payroll, inventory, or rent. Unlike a traditional loan which provides a lump sum upfront, a line of credit allows businesses to borrow as needed up to a set limit. Much like a business credit card, interest is only charged on the amount borrowed, making it a cost-effective solution for managing cash flow fluctuations.

This type of credit is revolving, meaning businesses can repay and reuse the funds as long as they stay within their limit and meet repayment terms. Lenders typically evaluate factors like revenue, credit history, and financial stability before approving a line of credit.

There are both secured and unsecured working capital lines of credit. Secured options require some sort of collateral to back the loan.

Pros and cons of a working capital line of credit

Working capital lines of credit may be exceptionally useful for your business, but they aren’t the best fit for every situation or every business. Like any small business loan or financial tool, they come with unique advantages and disadvantages.

Pros

• No business equity lost: Unlike other business financing options, you don’t have to trade money for a portion of your business. A working capital line of credit allows you to maintain full ownership and control of your business.
• Unsecured and secured options: There are options for both unsecured and secured working capital lines of credit. A secured option can offer you more favorable interest rates, but unsecured options are there even if you don’t have collateral.
• Flexible spending options: With a line of credit, you can decide whether or not you want to spend up to your allowed limit. If you need cash, you have access to it, but you don’t need to use your line of credit if cash flow is good.

Cons

• Secured line of credit required without high credit: If your credit history is poor or even mediocre, you’ll likely need to back your working line of credit with some sort of collateral, often requiring you to put up your business inventory or property. This puts your business assets at risk of seizure if you fail to make your payments on time.
• Impacts business owner’s personal credit: A working capital line of credit is tied to the business owner’s personal credit. That means any negative impact from the line of credit can hurt their personal credit score.
• Potentially higher interest rates than other business loan types: Working capital lines of credit come with fast funding. This means underwriting criteria are more relaxed than other loan types, but it also means interest rates are higher than other loan types.

Where to get a working capital line of credit

If you need cash for your business soon, a working capital line of credit may be the best way to get it. Look to business lenders, banks, credit unions and community organizations for options. Consider multiple line of credit options in your search. Compare interest rates, whether the line of credit is secured or unsecured and repayment terms to find the best option for your business.

Here are the most popular options for those looking to get a working capital line of credit:

Bank or credit union

Traditional lenders like banks and credit unions offer a variety of business financing options, including working capital lines of credit. Not all traditional lenders offer this, though. Start your search by talking to lenders with whom you already have a relationship and ask them if they have what you’re looking for. If they can’t help you, expand your search. It is worth noting that Wells Fargo and First National Bank are two large financial institutions that offer working capital lines of credit.

Online lender

Getting a working capital line of credit from an online lender means more flexibility. While these lenders do not have physical brand locations to visit, they often have online applications and customer service channels with extended hours. They can also offer some attractive terms. For example, Bluevine offers instant access to funds once you are approved.

Business loan marketplace

A business loan marketplace such as Lendio can offer you a variety of compelling options for a working capital line of credit. These marketplaces allow you to compare options to determine the best fit for your company’s needs.

Small business administration (SBA)

The Small Business Administration (SBA) offers a working capital line of credit to eligible businesses. The 7(a) Working Capital Pilot Program is administered by private lenders, but the loans are backed by the SBA. This means businesses get a working capital line of credit for up to $5 million with more competitive interest rates than other options.

Bottom line

If you need cash soon to cover everyday business expenses. A working capital line of credit could be the right option. This business financing type is best for businesses that have cyclical cash flow or expect an increase in cash flow soon.

Consider all your options. Working capital loans of any type come with pros and cons. There may be business financing options that fit your needs better than a working capital line of credit. However, if you decide to pursue one, consider multiple lenders. Compare interest rates and repayment terms before you choose a working capital line of credit.

Frequently asked questions

• Are working capital loans a good idea?
  

  A working capital loan can be a good option if you need cash to operate your business in the short-term. Both working capital loans and working capital lines of credit function with the assumption that your business will have more cash soon.

  If you are not sure about your business’s future cash flow, consider a different financing option. Using a working capital loan without the ability to pay it back means you’ll accrue high interest and even more debt.

• What credit score do you need for working capital?
  

  Credit score requirements for a working capital line of credit vary by lender. Most lenders will want you to have a score of at least 620. Some lenders may offer you a working capital line of credit with a lower credit score, but it will likely come with a higher interest rate than other options.

• What are the risks of working capital financing?
  

  When you open any type of working capital financing, you take on certain risks. These financing options are tied to the personal credit score of the business owner, so any late payments or negative activity on the loan lowers their credit score. You also run the risk of being unable to repay the lender if you don’t make back the cash expected.