More than 50 percent of businesses fail within the first four to five years. There is a lot of reasons as to why this is the case, but one of the most common reasons is due to poor cash flow.
Startup businesses are forced to acquire some sort of capital to cover large purchases and expenses. As a result, many businesses seek out Working Capital Loans from financial institutions to help decrease overhead, job costs, operational expenses or even extend credit to customers.
But, this can come with a price that is often more costly than writing a giant check at the end of the month; it can cost businesses everything. Literally.
What Are Working Capital Loans?
Many working capital loans are treated as a “band-aid”—a way for businesses with bad credit or bad cash flow to help pay their bills, their employees, or make other large purposes. This not-so-great business funding method has put many businesses further underwater, causing them to sink before they can learn to swim.
Working capital loans are usually acquired due to poor cash flow and poor cash flow management. Rather, working capital loans should be used as a short term loan rather than a long-term solution. Working capital loans are a treatment, not a cure.
Businesses should become more educated on the underlying issues of working capital loans, and why cash flow issues should be addressed before resorting to taking out a working capital loan.
The Cost of Working Capital Loans
Extending credit to customers is convenient and increases customer loyalty with your business, but it might not be so convenient for your business. Extending credit to your customers comes with a price.
In some cases, your business may need to wait over a month to see its receivables. As a result, this much-needed cash may hold you back from paying your employees, making large and necessary purchases, paying creditors or making important investments.
As a result, many businesses turn to working capital loans to help them “bridge the gap” between paying employees while waiting for customer payments. This ends up being a pretty expensive way to finance paying your invoices. For some businesses, particularly those with poor credit, it's sometimes the only solution.
If not handled correctly, working capital loans can keep your business from moving forward or getting ahead.
What the Working Capital Loan Equation Really Looks Like
It might bring you some relief when you see a large lump sum of money hit your bank account after acquiring a working capital loan, however, don’t be fooled. Many of these loans are associated with extremely high interest rates and fees. So, when you break down the math, that loan only ends up paying a fraction of your bills and harms your gross profit.
In fact, working capital loans typically only pay for 70 to 85 percent of the invoice value. If your customer pays his or her bill in full, then you subtract the cost of the loan from your accounts receivables, you really only receive approximately between 15 and 30 percent of what your customer paid you.
Although it still might feel like a win if you successfully paid your bills and received payment from your customers, think agai You are still prompting your customers to pay their invoices on time. So, you are still putting in the time and risk every month to get them to pay. So, once you factor in your time and risks, your profit margin decreases pretty quickly.
A Long-Term Solution to a Temporary Fix
Think of your cash flow issues like a car that is leaking gas or oil. Do you throw some duct tape around the leaky fuel or oil line, fill it back up and call it a day? No, you probably don’t. You may leave it as a short-term fix until you can get your car to a mechanic, but you know you eventually need to replace the leaky line with a new one.
The same goes for your business’ cash flow. You wouldn’t throw a band aid or some duct tape over a potentially dangerous issue and call it “fixed”. You want a long-term solution that allows you to improve your business’ credit, get ahead, and move forward.
Furthermore, once you are aware of an issue, and also how it could become a larger issue, you quickly realize a temporary, short-term fix from a long-term, solid solution.
A Work Around to Working Capital Loans
Now that you understand how and why working capital loans aren’t necessarily the best solution for poor cash flow, what are some real, long-term solutions?
- Reduce Days Sales Outstanding. If your business is struggling with cash flow, your first step should be to look at your books. Businesses with organized finances will be able to quickly report on the business’ average Days Sales Outstanding (DSO). This is the average amount of time it takes customers to pay you.
In order to ensure sufficient, healthy cash flow, your DSO should be equal—or less—to your days payable outstanding to be considered profitable. After all, if you don’t have any cash, then you can’t pay your bills.
- Reconsider Customer Credit. As we mentioned above, customer credit is incredibly convenient for customers and increases loyalty with your business, but what if they never pay? Customer credit comes with a lot of risks, and may not be the best option for new startup businesses.
Businesses that must offer credit should carefully review review customers’ credit scores and only extend credit to qualified customers. You should also consider a more lengthy and detailed application process in order to ensure that you only extend credit to creditworthy buyers.
Remember, most businesses fail to realize that a late payment is also a temporary loss.
- Reduce Operating Expenses. It might be easier said than done, but many businesses think that all of their operating expenses are necessary. They probably aren’t. It might take a little creativity, but businesses are likely to be able to find some expenses that they can do without—at least until cash flow improves. Find these expenses and get rid of them as soon as possible.
- Pay Bills On Time. If extending payment terms with suppliers with help your cash flow, then you need to build up a good, solid payment history with them. Paying bills on time or even early will show suppliers that you are dependable and reliable. Therefore, they will be more likely to give you a longer payment term if you ask for one.
Wouldn't it be great if business finance and making money was quick and painless? We all know that money doesn’t come easy. Building up healthy, proper cash flow takes a lot of planning, steps, and making strategic decisions to keep expenses and overhead as low as possible to avoid racking up debt.
Rather than treating working capital loans as a pay day, be sure to carefully calculate what that loan will cost you over the life of the note, and break down how much the cost of the loan will take away from what you profit from when you receive your customer payments.
A lump sum of money isn’t all that it’s cracked up to be. Avoid the “duct tape fix” and focus on the long-term solution for your business.