Arranging the finances for your business and making sure you never run out of funds necessary for its day to day operations is one of your key responsibilities as an entrepreneur. However, inadvertently businesses run into situations where they are unable to secure enough capital to run their operations smoothly. One of the best ways to get out of this fix is by availing a working capital loan.
What is a Working Capital Loan?
A Working capital loan is a loan that is offered to businesses and companies to carry out their day to day operations. These are short-term loans and are taken by the companies to cover their immediate operational costs like salaries, rent, sales and marketing costs, etc.
How Working Capital Loan can help you?
Following are the four most important benefits of a Working Capital Loan.
Handle Immediate Financial Requirements Working capital loans are a great way to replenish a company’s coffers for the short term so that the day to day operations can run smoothly. These loans help the company fill the gaps between the cash inflow from their clients and the payouts, ensuring that all the financial requirements meet on time.
Helpful for cyclical businesses Many businesses have specific cycles that they undergo during a year, wherein the demand for their goods or services jumps up during a certain period while it stays dormant during the rest of the year. Short term working capital loans are a great way to ensure that all the financial requirements are met before the active period starts so that the company faces no shortages of funds and can go full throttle to meet the heightened demand.
Freedom on Expenditure Unlike most other loans, working capital loans do not dictate the applicant on how to spend the loan money. This means that the borrower has full freedom and discretion to use the money in the best interest of the business.
Business owners mantain full control over their company Working Capital finance is a form of Debt Finance and has no impact on equity of the company, which means the owner gets access to funds without having to lose any control over ownership of his company.
Types of Working Capital loans
The types of working capital loans that are available to businesses in India are
- Working Capital Term Loan
- Bank Guarantee
- Bill Discounting
- Letter of Credit or LC
- Invoice factoring
- Trade Credit or Line of Credit
- Cash Credit & Overdraft
We have further explained each of the types listed above in detail.
Working Capital Term Loan
Term loans are the simplest form of loans in which the lender hands over the sanctioned amount to the applicant after making thorough inquiries about their ability to pay it back. The loan is required to be repaid in fixed monthly installments along with interest. These loans are mostly secured and require some form of collateral. However, if the lender is satisfied with the creditworthiness and the business continuity of the applicant, they may sanction the loan without any collateral as well.
Bank guarantee is acquired by the seller or buyer to outweigh the possible risk due to non-performance of a certain agreement. It could be anything from a payment to the promise of service. The holder only repeals it on non-performance by the other party. With a Bank Guarantee being a part of trade transaction, the supplier and buyer can conduct their business dealing with security of receiving the payment and goods. It is a non-fund based working capital loan, which means having a Bank Guarantee does not include getting access to funds, it is merely a guarantee that the supplier will receive his funds if he delivers the goods as per agreement. The bank asks for some security and charges commission for providing this service.
Bill discounting is a process of acquiring funds in advance from a lender against confirmed sales orders. If a seller is running short on cash and has sold their goods to a single or multiple buyers for which they are yet to be paid, they can sell those bills to a lender at discounted rates. The lender immediately sanctions the cash to the seller, deducting some amount from it as interest. It collects the bill amount from the buyer at the time when the payment is due.
Letter of Credit (LC)
If a business wants to secure a working capital loan to carry out a transaction, they can apply for a 'Letter of Credit' (LC) to a lender (banks or NBFCs). Once the lender sanctions the letter, the buyer can then send it to the supplier instead of payments. If the supplier wishes to access the funds right away he can take this Letter of Credit to a bank or any other financial institution who can "discount" the LC and remit the due funds to the supplier after deducting interest. The buyer has to pay the amount against LC to the lender within the agreed-upon time limit.
Invoice factoring is one of the fastest and easiest ways to offset the impact of outstanding account receivables on your cash flow. Under invoice factoring the business can sell their invoices or accounts receivable to a factoring company. The Factoring Company immediately transfers 80-90% of the invoice value to the supplier and the remaining funds are transferred after deucting interest, once the factoring company receives the payment from the buyer on due date. Invoice factoring is one of the easiest working capital solutions for any trade transaction having a certain credit period as part of the payment terms as it allows suppliers and buyers to conduct trade with more flexibility. Another benefit of Invoice Factoring for suppliers is it is an off balance sheet funding, and can be obtained over and above the existing credit line from your bank.
Trade Credit/Line of Credit
Trade credit is an agreement between agencies engaged in business in which the supplier extends a line of credit to the recipient i.e. payment for the goods can be made at a later stage. Trade credits are given for a period of 30 to 90 days. In some businesses, however, trade credits are given for a longer period. The creditworthiness of the recipient plays an important role here.
Cash Credit & Overdraft
Cash credit and Overdrafts are the most widely used form of working capital loans. Here, a bank or any other lender sanctions a cash loan up to the businesses by setting up an account. The applicant may borrow any amount of cash from this account up to a certain maximum limit fixed by the lender. For such loans, the interest is applicable only on the borrowed amount and not the maximum limit.
Example: If a company can borrow up to INR 50 lakhs from their account but decides to only avail 35 lakhs, the interest rate shall be charged on INR 35 lakhs i.e. the borrowed amount, and not 50 lakhs i.e. the maximum limit.
Even though Cash Credit and Overdrafts are the most widely known working capital products, it is difficult for most Indian SMEs to aquire them as banks generally require hard collateral and organised financials for approving these loans. Also, the working capital limits or the amount of funding sanctioned by the banks may not be enough to fulfill the working capital requirement of the business.
Secured vs Unsecured Working Capital Loans
It is important to understand whether the Working Capital Finance solution you are looking for is secured or unsecured. It will determine whether you are eligible for getting access to a certain type of working capital loan, and it will also impact the process of application for the loan.
Secured Working Capital Loans
To sanction a loan, the lender will ensure that the applicant is capable of paying back the amount with the interest. The best way to do that is to give loans against assets owned by the applicant. When a lender sanctions a working capital loan against assets as security (also known as collateral), it is known as a secured working capital loan. The loan amount which will be sanctioned is based on the value of the collateral which the borrower has to pledge to the lender. In case the borrower defaults in repayment of the loan, the lender can liquidate the asset and recover the loaned amount.
Following are the types of assets that can be extended as security for getting secured working capital loans:-
- Commercial & Residential Property
- Stocks, Mutual Funs or Bond Investments
- Insurance Policies
- Lands which are clearly demarcated (Non-agricultural)
Secured working capital loans are cheaper in terms of interest rate but are difficult to obtain because of either unavailibility of collateral or legal issues with respect to ownership of property. Also, the procedure in applying for a secured working capital loan is much more time taking because evaluation and pledging of the collateral is a lengthy process.
Unsecured Working Capital Loans
Unsecured working capital loans are lending instruments that do not need any collateral. The applicant’s ability to pay the sum back is judged based on their creditworthiness of the businesses. The bank undertakes a thorough investigation into the financial records of the company before sanctioning unsecured working capital loans.
Unsecured loans may have a higher interest rate as compared to secured loans, but the process of evaluating the application and disbursement of funds is much faster because of absence of collateral in the process.
How to apply for a working capital loan?
Once you decide to aquire working capital loan for your business, here is how you can apply for it:-
- Explore your options as to which Bank, NBFC or alternative financing company do you wish to apply to and compare their rates.
- Once you figure out which option is best suited to your needs, contact the lender on their website or visit their branch near you.
- Apply for a loan by submitting the required documents.
- Once the lender approves your application and sanctions the loan, the amount is credited to your bank account within a stipulated period.
What are the eligibility criteria for a Working Capital Loan?
The most important eligibility criteria for any loan is the applicant’s creditworthiness. When you apply for working capital loans from banks and other NBFCs, they investigate your creditworthiness by a variety of parameters -- knowing your business, deep-diving into your and the company's financial statements, etc. The detailed criteria for securing a working capital loan are different for every business. Most traditional banks gauge your application on the following parameters:
- Applicant’s and the Company’s Bank Statements
- Company’s Balance Sheet
- Proof of Time in Business and Business Continuity
- The Applicant’s Credit Score
- Applicant’s and the Company’s Tax Reports
- Collaterals/ Assets owned by the Applicant and the Company
What are the documents required for a Working Capital Loan?
Although the exact list of documents required to get a working capital loan depends on the nature of business of the applicant as well as the policies of the lender, here are the most commonly required documents:
- PAN Card
- Passport Sized Photographs of the Applicants and the Co-applicants
- Identity Proof
- Address and Income Proofs
- Business Continuity: Last three years’ income tax return (ITR) and bank statements
- Credit Monitoring Arrangement (CMA) report, if business' turnover is more than Rs 5 cr
- Last two years’ of the audited financial report
- Partnership deed
- Certificate of registration
- Certificate of incorporation
- In the case of multiple directors, the name of all the present directors on company letterhead
- Memorandum of Association (MoA) and Articles of Association (AoA)
How to calculate the amount of working capital loan that your business needs?
The working capital of any company can be calculated by this formula:
Current Assets – Current Liabilities = Working Capital
As the formula suggests, the working capital of any company is the liquid assets that remain once the liabilities are paid off. This is a great way to measure the company’s ability to carry out their short term operations and manage the day to day costs.
To run your business smoothly, you must maintain a good asset to liability ratio, which is also known as the ‘working capital ratio’. It is one of the key indices to measure the financial well-being of any organization.
Working Capital Ratio = Current Assets / Current Liabilities
A healthy working capital ratio is anywhere between 1.4 to 1.6. If your business suffers from a poor working capital ratio, you may need to secure additional funds to perform your day to day business operations. A working capital loan provides you with ready to use cash and helps you keep a healthy working capital ratio for the short term while you balance your liabilities against your assets.
FAQs on Working Capital Loan
1. What is the difference between working capital and term loan?
Working capital loans are a short-term loan availed to manage the day to day expenses, while term loans are generally medium to long term loans and borrowed keeping in mind a long term goal.
2. Where does working capital loan go on a Balance Sheet?
Since a working capital loan is a part of short term debt, it is reported as a liability on the company’s balance sheet.
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