Working capital financing: what it is and what it really costs

Working capital financing is money that covers the gap between paying your costs and collecting your revenue. For an established US business it usually comes as one of four shapes: a merchant cash advance, revenue-based financing, a business line of credit or a short term loan. They can cost wildly different amounts for the same dollar, so the first job is to put every offer into one number you can compare: the APR on the money you actually receive.

What working capital is for

Working capital pays for the running of the business, not for things that last. Typical uses:

• Payroll through a slow month or while a big contract ramps up.
• Inventory bought ahead of a busy season.
• Supplier bills that fall due before your customers pay you.
• A specific opportunity, such as a bulk discount for paying a supplier early.

If the money is for a machine, a vehicle or a fit-out that will earn for five years, it usually belongs in equipment financing or a term loan instead. Paying for a five-year asset with six-month money means paying the highest price per year for the longest-lived thing you own.

The four main shapes

There is also the SBA loan route through your bank, which is usually cheaper but slower and more paperwork-heavy. Ask Sterling and our funding partner don't arrange SBA loans.

How the cost works

Working capital products describe their price in different ways: a factor rate on an advance, an interest rate on a loan, a fee per draw on a line of credit. The only fair comparison is to turn each one into an APR on the cash you actually get.

Take the canonical example. A $10,000 advance at a 1.35 factor rate (the fixed multiple you pay back) over 6 months, paid daily, means you pay back $13,500 in 126 payments of $107.14. The cost is $3,500, which works out at about 126% APR. Scale it up and the APR stays the same: $100,000 at 1.35 means $135,000 back, $1,071.43 every business day for 6 months.

Compare that with a term loan of $100,000 at 18% APR over 24 months, repaid monthly: $4,992.41 a month, $119,817.84 in total, $19,817.84 of interest.

The 6-month and 12-month advances cost the same dollars, but the shorter one costs twice as much per year because you have the money for half as long. That is why the APR, not the dollar cost, is the number to compare. Use the MCA APR calculator to convert any factor-rate offer.

Fees taken off the top make it worse. If $3,000 of a $100,000 advance at 1.35 over 6 months daily goes on up-front fees, you receive $97,000, still repay $135,000, and the APR rises to about 140%.

Some states make providers do this maths for you. California requires providers to disclose the total funds provided, the total dollar cost, the term or estimated term and the payment amounts for commercial financing offers of $500,000 or less. New York requires sales-based financing offers to show an estimated annual percentage rate. Wherever you are, you can ask any provider for those numbers in writing.

Who it suits, and who it doesn't

Working capital financing suits a business with steady deposits, a specific short-term gap and a clear way the money pays for itself. A restaurant buying stock at a bulk discount before summer, or a distributor fulfilling a confirmed order, fits that description.

It does not suit covering a loss that keeps recurring. If the business spends more than it earns every month, borrowing adds a repayment to the hole. Fix the margin first.

Our funding partner's programs suit established businesses: 12 or more months trading, about $80K or more a month in deposits, a personal credit score of 600 or more, two or fewer advances or loans already running, and an applicant who owns 51% or more. Smaller businesses doing $15K or more a month with 4 or more months of trading can still ask; there is a route for them. Amounts run from $50K to $500K+, subject to the funder's checks.

What lenders look at

• Bank statements, usually the last few months. Funders look at average deposits, the lowest balances and how often the account goes negative.
• Time in business. A longer track record lowers the risk they price in.
• Existing advances. Each running advance takes a slice of your deposits before a new one does.
• Personal credit. Most funders check the owner's score, even for business money.
• Industry. Some industries are harder to fund because of how cash moves through them.

Red flags

• An offer quoted only as a factor rate or a "small daily payment", with no total payback and no term.
• Fees deducted from the amount you receive that weren't in the first quote.
• Pressure to sign the same day.
• A second or third advance offered while the first is still running, a practice called stacking.
• Anyone who asks you to pay a fee before you get an offer. See our page on funding scams.

Sterling's take: if an offer can't be written down as amount received, total repaid, number of payments and payment size, don't sign it.

How to choose

Start with the gap. If you know when and how the money comes back, a fixed product works. If you don't, a line of credit or a revenue-share product flexes with you. Then price each option as an APR, check the daily or weekly payment against a slow week, and use the borrowing calculator to see what fits your revenue before anyone quotes you.