How to Manage a Working Capital Loan

A working capital loan can give you a way to weather the storm of a cash shortage or jump on a business opportunity. But if you’re considering a short-term business loan, line of credit or any other option to bridge a cash flow gap for your business, you need to make sure you understand the big picture. Yes, this loan might help you today. But how will it impact your financial future?

You’ll need to be able to manage the loan repayments to ensure that you can  make all payments on time until the loan is paid off. Taking out a loan that you can’t reasonably pay back is a form of bad debt, and you should avoid this scenario. Instead, make a plan to repay the loan before you sign for it to set you off on the right foot.

Tips for managing a working capital loan

Before you sign on the dotted line, research short-term loans and make sure you understand the total monthly payment and any fees. Then, follow these tips to make sure you can manage your working capital loan.

1. Understand your loan agreement

Before signing for a short-term business loan or any other working capital loan, read through your loan agreement and make sure that you fully understand the terms of the contract. Once you sign, the agreement is legally binding.

Here are some key aspects of your loan agreement that you need to understand:

2. Fit loan repayments into your business budget

Once you understand your potential loan agreement, you need to make sure it fits into your overall business budget.

Your business budget should look at current and projected revenue, fixed costs (payroll, leasing costs, subscriptions, insurance, taxes) and variable costs (marketing, utilities). You need to make sure the total of your expenses, including your business loan repayments, is less than the revenue that you bring in over the course of a month.

Your business budget should also look ahead to forecast revenue for the upcoming months and year. Generally, lenders want to see two years of financial reporting for a company before issuing a loan. Looking back over your business’s revenue and spending over the last two years can help you build a business budget you can trust.

3. Pay your bills on time

Paying on time boosts your credit score and helps you avoid unnecessary costs, like late fees and penalties. This doesn’t just apply to working capital loans for small businesses. You need to pay on time to your utility providers, creditors and suppliers on time.

For help, ask if any of your bill issuers offer autopay (most working capital loan lenders will). This way, they can make an automatic draw from your business bank account, so you don’t need to write a check or log into your account to pay.

4. Keep debt to a minimum

Working capital loans for small businesses can be a huge help or a potential pitfall. Because these loans may require fast repayments over a short term, it’s easy to fall into a cycle of debt. To keep up with the payments for your loan, you might be tempted to take out another loan or put it on your business credit card. But this way, debt builds up — and so does the interest your company has to cough up.

While managing a working capital loan, avoid taking on new debt unless you have a solid plan to repay all your debts. As a rule of thumb, you want to keep your debt-to-income ratio to 36 percent or less and your debt service coverage ratio (DSCR) to 1.25 or higher. The DSCR measures how much revenue you have to cover all your debts, a tool that lenders use to see if you can handle new debt.

If you run into financial issues while paying back your working capital loan, consider zero-debt financing for your small business, such as crowdfunding, bootstrapping or grants.

5. Check your credit

You might think your credit score only matters when you’re trying to get a loan, but it can be a huge help as you manage your loan. If you have high personal and business credit scores, you’ll be better positioned to negotiate with your lender if you ever have trouble making payments.

Periodically check your business credit report and personal credit score. As you pay back your working capital loan, those should go up. You can also boost your business credit score by reporting any trade credit that you receive through your business’s suppliers. Also, make it a point to get a credit report at least annually and go through it line by line. If you find an error, dispute it to give you a credit score bump.

6. Talk to your lender

If you ever think you might be in a position to miss a payment, talk to your lender before that payment date. While lenders are more than happy to collect late fees for one missed payment, they don’t want you to go into default. Collections or legal proceedings cost them money and effort, and they would rather avoid that outcome.

As a result, your lender might offer an option like:

• Short-term repayment modifications, like interest-only payments
• A loan term extension
• Short-term deferment or forbearance, which cancels payments for a time
• A loan settlement amount to settle the debt for less than you owe

Your lender is more likely to agree to an adjustment if you have a good reason for making the request (like a seasonal ebb or a personal emergency) and a good credit score. In any case, it’s always worth contacting your lender to explore your options.

What happens if you don’t pay a working capital loan?

Working capital loans for small businesses help some businesses thrive, but they tank others. One missed payment will likely land you with fees and cause a dip in your credit score. But if you continually miss payments and your lender’s grace period expires, you enter default.

At this point, the lender can accelerate loan repayment, which means you owe the full sum of whatever they lent you. If you can’t repay it (a very likely outcome), you put anything you used to secure the loan at risk. While you can get an unsecured working capital loan — often in the form of a line of credit or a high-cost option like a merchant cash advance — the best loan rates come from secured financing. That means you put up business collateral, made a personal guarantee or both.

The lender can seize any business collateral you used to back the loan, such as high-value assets like real estate or equipment, in order to repay the loan in full or part. If you signed a personal guarantee, the lender can also go after your personal assets.

Plus, defaulting will tank your credit score and seriously limit your financing options moving forward.

Bottom line

The best working capital loans can be the boon your business needs — but only if you manage them well. Before you sign for a loan, make sure you’ve explored all of your short-term financing options and you clearly understand the one you plan to use.

Then, once you get the loan proceeds, stay diligent about managing them and your company’s overall finances. As you repay your working capital loan, your credit score should grow.

Frequently asked questions about how to manage a working capital loan

• Is a working capital loan good or bad?
  

  It all depends on how you manage it. Because these loans are generally easier to get, they can greatly help businesses needing cash infusion. But if you don’t manage the loan and repay what you borrow in the agreed-upon timeline, it can risk your credit score and business and personal assets.

• When should you get a working capital loan?
  

  Businesses might consider a working capital loan to weather a seasonal downturn, invest in needed equipment, bring on headcount or otherwise bump up cash flow. But you should only get a working capital loan if you’re confident your business can pay back what you borrow on a quick repayment schedule.

• How much can you get for a working capital loan?
  

  That depends on your lender. Online lenders might offer as little as $10,000, while an SBA working capital loan can go up to $5 million. The lender will assess your business’s finances and determine the loan amount that your business can handle.

   

• What is the best way to use a working capital loan?
  

  The best way to use a working capital loan is to cover short-term expenses, seasonal cash-flow dips, or to increase the value of your company — whether that be investing in new equipment, buying inventory or bringing in more staff to accommodate customers. That said, you should only take out a working capital loan if you’re certain you can stick to the payment schedule and won’t fall into a cycle of debt by agreeing to one.