A working capital loan is a loan that is taken to finance a company's everyday operations. These loans are not used to buy long-term assets or investments and are, instead, used to provide the working capital that covers a company's short-term operational needs. Those needs can include costs such as payroll, rent and debt payments. In this way, working capital loans are simply corporate debt borrowings that are used by a company to finance its daily operations.
Working Capital = Current Assets - Current Liabilities
Working capital loans are provided for financing everyday operations of a company and used to cover or build-up current assets like inventory, stock-in-trade, accounts receivables, etc. Some of the types of working capital facilities are cash credit, overdraft, letter of credit, bank guarantee, packing credit, post shipment finance and bill discounting.
The loan is usually repaid by the time the company hits its busy season and no longer needs the financing.
The working capital loans are made for using a specific purpose, i.e. dealing with daily business operations, however there can be some different reasons for borrowing money from a lender.
Have a look at the top reasons for taking a working capital loan.
1) Seasonal sales fluctuations
It is the most common reason to take out this sort of loan. It helps to pay the everyday expenses when the sales get slow. There can be a chance that businesses take out working capital loan before a busy season for allocating their capital somewhere else.
2) Cash Cushion
The working capital loan can be useful if the business doesn’t have adequate cash reserves. This ensures that they have additional capital in case of any emergency.
3) Non-steady cash flow
Some businesses take a longer period of time for paying invoices and that’s why their inventory takes a lot of time for turning it over. This sort of loan can be used for boosting the cash flow so that they always have the money whenever they need it.
4) For capitalising on an opportunity
It can be quite frustrating to lose a big opportunity due to insufficient funds. A working capital loan can help a business owner in grabbing that opportunity by offering the required funds. It can turn out to be good for the business in the long run.
So, if you own a seasonal business and often face risks and challenges that create problems in your annual revenues, then you should go for a working capital loan. These loans can absorb the blows created by these risks as having enough cash flow is the key to success. It will not only cover your day to day operating expenses but also helps in investing in the future operations of your business.
The working capital loan will help your business to fill larger orders by covering the expense of manufacturing and shipping the product. It will carry your business until you get the payment for your order.
Types of financing include a term loan, a business line of credit or invoice financing, a form of short-term borrowing that is extended by a lender to its business customers based on unpaid invoices. Business credit cards, which allow you to earn rewards, can also provide access to working capital.
The working capital ratio is another way to compare a company's current assets to its current liabilities. Unlike the traditional working capital formula (current assets - current liabilities), the working capital ratio puts current assets in the numerator and current liabilities in the denominator.
Here's the formula for the working capital ratio:
Working capital ratio = current assets / current liabilities
or,
Working capital ratio = (cash + short-term investments + inventory + accounts receivables) / (short-term notes + accounts payables)
This ratio is usually expressed as a multiple. A working capital ratio of 1.0 means that a company's current assets are equal to its current liabilities. A working capital of 2.0 means that company has twice the amount of current assets as it does current liabilities, while a working capital of less than 1.0 indicates a negative working capital where the company's current liabilities exceed its current assets.
Depending on the analyst you ask and the company's industry, a working capital ratio between 1.1 and 2.0 typically indicates a healthy working capital ratio where a company is managing its cash wisely and minimizing its risk of defaulting on its bills. A working capital ratio of more than 2.0 with a relatively low cash amount may mean the company is moving its inventory too slowly, collecting its receivables too slowly, or paying its vendors too quickly -- all of which could lead to cash shortage and repayment problems if cash levels are low.
Pros
No need for any collateral
If you have a good credit history, then you may become eligible for unsecured working capital loans. You don’t need to put up your inventory, business or any important thing for securing the loan. However, the payment of the loan is critical as the banks will come after you.
Speed and Flexibility
One of the biggest benefits of working capital loan in India is that eligible firms can get short-term loans that include inventory loans, accounts receivable credit lines or bank lines of credit in a shorter period of time. These loans are generally flexible with varying repayment terms and interest rates, that help the firms with the seasonal fluctuations in smoothing out their cash flow.
Spending money at your discretion
Generally, the working capital loan has little to zero restrictions. The only thing lender expects is that you are using the cash for increasing revenue or maintaining daily operations.
Cons:
If you are looking to apply for a working capital loan in India, you need to represent a business that has been in operation for a number of years or your business should have a certain annual turnover. However, the requirements depend on the type of business you own.
There are various kinds of working capital Loans. Some of them are as follows:
Working Capital Short-Term Loans
Business capital in the form of a short-term loan is the most typical type of working capital loan. With short-term business capital loans, you’re given a lump sum loan that’s paid back over a shorter period of time: Typically, from 3 to 18 months.
Working Capital Lines of Credit
Business capital access through a business line of credit is a particularly flexible option for small business owners. Use a line of credit like a backup plan when working capital goes negative. Once you apply and are approved for a business capital line of credit, you’re given access to a pool of funds that you can tap into whenever you need to.
Merchant Cash Advances
Working capital loans can also come in the form of merchant cash advances. Merchant cash advance companies advance you a sum of cash, which you’ll pay back by allowing the company to take a fixed percentage of your daily credit card sales. While this is an easy working capital solution, it’s the most expensive kind of business capital .
Invoice Financing
Business capital frees up if you access invoice financing for your outstanding invoices. Invoice financing is a solution for business owners whose working capital is tied up by the fact that customers are late to pay their invoices. Invoice financing helps you to access business capital immediately for your outstanding invoices, freeing up cash to use for your business’s daily operations.
Bank Overdraft Facility
Your company’s relationship with the lender decides the interest rate and the maximum line of credit that you can receive. One great benefit of the bank overdraft facility loan is that you only need to pay the interest that is applicable on the overdrawn amount. However, the rates are generally set above the prime rate of the bank.
Account Receivable Loan
The account receivable loans are based on the confirmed sales order value of a business. It is perfect for a company who require funding for filling a sales order. However, you need to be reputable and have a good credit history for getting this type of working capital loan.
DOCUMENTS REQUIRED FOR BUSINESS LOAN IN INDIA
Following are the documents:
Following are the factors:
Credit score
The applicants having a good credit score can easily walk into any bank to get a business loan and the better you score, the more you can avail. The rate of interest will also depend on the same.
Time in Business
The minimum operation period is of two years or more irrespective of what type of business it is. Longer the existence of the business more will be the probability of getting a loan.
Monthly Revenue
Revenue is always a key factor for any type of loan. But for a business loan, the consistency is the main factor. Generally, all business has different revenue at a different period, but having consistency is crucial. The balance of day-to-day is analysed by the banks to determine the loan amount and repayment capability.
Collateral
The security is pledged with a bank loan. More the collateral value, more will be the benefits. It provides security to the banks to offer bigger amount as the risk is low. There are different types of collaterals such as deposits, home equity, investment real estate, and equipment.
Not always. If you're include a company's "rainy day" reserve cash in its assets within the working capital formula (current assets - current liabilities), then a large amount of working capital is a good indicator that the company will be financially able to repay its payables and other short-term debt even if business were to suddenly dry up.
However, if you're using only a company's cash needed for "day-to-day" operations in the current assets part of the working capital formula, then a large amount of working capital with a relatively small amount of cash could mean problems.
While a negative working capital amount typically warns that a company has more short-term debt than it has in cash and other assets, it sometimes be a smart use of cash resources depending on the company's business model.
