Working capital is an important component of your business’s financial picture – and for SBA loans, it’s also one of the most confusing concepts for borrowers. That’s because the U.S. Small Business Administration (SBA) defines working capital a bit differently for loan purposes than the traditional definition. As a result, you may be surprised by how this can impact your loan process when you secure financing for your business through an SBA working capital loan.
In this overview, you’ll learn the important differences between the typical definition of working capital and the way the SBA defines it, as well as how this can impact your decision-making about financing options.
Working capital: Traditional definition and uses
Working capital in the traditional accounting sense is defined as the sum of a business’s current assets, minus current liabilities. Current assets are short-term assets that can be converted quickly to cash. This includes your accounts receivable (AR) and inventory. Current liabilities are obligations that are due within one year, which are mainly your accounts payable (AP) and short-term debt.
A business can have either positive or negative working capital. Positive working capital means your business can cover its day-to-day expenses and still have funds set aside for unexpected expenses or opportunities. On the other hand, negative working capital means your business may not be able to cover key expenses like inventory, rent, payroll, and suppliers.
Here’s another way to think of working capital: it’s the money that’s leftover if you paid off all your current liabilities with your current assets. The basic formula is:
Working capital = Current assets – current liabilities
It can also be calculated and expressed as a ratio:
Working capital ratio = Current assets / current liabilities
To make your working capital calculation even more actionable, you can determine how much working capital you have down to the number of days. To do so, divide your working capital by your daily operating expenses. This helps you to better understand your business’s working capital cycle.
Keeping all this in mind a conventional working capital loan can improve your business’s balance sheet by giving you more cash to purchase inventory or pay off accounts payables.
How is working capital designated for SBA loan applications?
Although you can use the traditional definition of working capital for your business financials, working capital is considered a bit differently for SBA loan applications.
When applying for an SBA working capital loan – or any SBA loan that includes a working capital component – the SBA considers “working capital” to be the elements of ongoing, day-to-day operational expenses like rent, payroll, insurances, and utilities. It can also include one-time expenses that come up as part of your loan project, including securing permits, licenses, and any required business or equipment valuations.
For SBA loan applications, other items that would improve your balance sheet – such as inventory or equipment purchases or paying off outstanding accounts payable – are separate lines and not included as part of your working capital component.
When an SBA loan closes, the items separate from the working capital component will likely be paid directly to vendors, rather than included as part of your lump-sum payment. This helps the SBA ensure you’re paying vendors as agreed, as well as using the funds as stated in your application to strengthen and grow your business.
What does a working capital loan application and disbursement look like?
Although these will still be part of your business’s balance sheet, for an SBA working capital loan application, tangible items like furniture, fixtures, equipment (FF&E), inventory, and supplies need to be separate budget lines. This differs from conventional bank loans, where you can include these items and funds for operational expenses all together as a working capital total.
Here’s a simplified example of how this could look when you apply for working capital using a conventional business loan from a bank versus the breakdown needed for an SBA working capital loan:
Conventional working capital loan: $20,000 (received as a lump-sum payment to the
borrower)
SBA loan including working capital: $12,000 (as a payment to the borrower)
$ 5,000 (inventory, disbursed to vendors)
$ 3,000 (FF&E disbursed to vendors)
Without knowing these differences in advance, you’d expect to receive the full amount of the loan to be deposited into your account, which can lead to confusion and concern. It’s particularly difficult if you didn’t request enough funding for your actual working capital needs.
How to ensure your SBA loan meets your business’s financing needs
To ensure that your SBA loan covers your financing needs, be upfront and clear about how you want to use your fund when talking with your lender. They’ll help you properly define each aspect of your loan request so that the breakdown meets SBA requirements while also giving you the right amount of financing to strengthen your business.
You’ll need to submit vendor quotes or invoices as part of the application and closing process for the tangible items included in your loan request. The rest of your working capital needs are a best estimate based on your projections, cash-flow analysis, and financial history. Your lender will review these with you, as well as your current needs and future goals, to ensure that you’re requesting enough working capital to achieve your vision.
What are potential sources of working capital for small businesses?
If you have a bank that you use for your business deposit accounts, you can always start your financing search with them. Find out what products they have available to meet your needs and learn more about their qualification criteria to see if your business is eligible.
In addition, community-based lenders, such as Community Development Financial Institutions (CDFIs), are non-profit financial institutions that offer affordable lending to underserved entrepreneurs and those who need more flexible terms to qualify for financing. CDFIs typically offer some of their own loan programs, as well as SBA loans programs. Together, these loan programs offer tremendous benefits to small business owners seeking working capital financing along with loans for commercial real estate, major equipment, and more.
These loan options offer you more flexible eligibility and approval criteria. Even if you’ve had past credit challenges, are launching a new business, or have a business in an industry that’s traditionally harder to fund – including retail, restaurants, and childcare – you can still be approved for loans through CDFIs. These loans have affordable interest rates and loan repayment terms that make it easier to reinvest in your business and grow.
Are there working capital sources that should be avoided?
In recent years, different types of working capital lenders have appeared on the market and targeted small business owners that have difficulty securing financing.
While they may initially appear to be helpful – especially if you’re in a bind for funds for payroll, rent, insurances, and other working capital needs – they often come with significant financial drawbacks that can put your business at further financial risk.
It’s worthwhile to know all of your options, but you should move forward with caution when considering options that seem too good to be true. These sources of working capital financing can charge annual percentage rates (APR) of 50% or more:
- Merchant cash advance programs: The amount you borrow is repaid using a portion of your future debit and credit card revenues (plus fees). While you’ll access fast cash, the repayment rates and fees often make them very difficult to manage, with hundreds and even thousands of dollars deducted from your credit and debit transactions daily.
- Invoice factoring: This is when you sell your invoices to a factoring company at a discount for quick access to capital. The repayment terms are short, typically 30-45 days, and the costs are very high.
- Online lenders that promise fast cash, no credit checks, no collateral, and other “too good to be true” promises, especially those with a one-year or less term, are extremely difficult to repay. These types of predatory loans are appealing when you need financing but can’t access conventional loans from their banks.
Pursuit has loans and a line of credit to guide you through working capital needs and more
Whether you want a working capital loan to launch or grow your business or you need financing to purchase or renovate your commercial property, purchase equipment, or more, Pursuit has you covered. Every day, we support small business owners in New York, New Jersey, Connecticut, Pennsylvania, Illinois, Nevada, and Washington through a range of tailored and beneficial loans. Contact us today to learn more about how we can help you – and if you’re outside of our service area, try the SBA Lender Match tool to find responsible small business lenders near you.
