A working capital loan helps the business meet its short-term financing requirements. There are many working capital financing options available in the market with their own set of advantages and disadvantages. Choosing the right option depends upon the individual borrower’s needs.
Working capital is a financial metric that reflects the liquidity levels of a company. A business opts for working capital financing to meet its day to day expenses. There are various options available to boost one’s working capital. Such loans are not meant for any asset purchase or long-term investments. Such loans can be secured or unsecured. The goal behind availing working capital finance is to ensure that the business has sufficient cash flow to meet its operational expenses.
In simple terms, working capital financing is a cash flow solution that helps the business keep operating by getting paid for ongoing projects or goods sold on credit.
Sources of working capital financing can be short term or long term. Let’s discuss a few of them:
(1) Banks: Commercial banks typically lend to good credit-rated companies. A borrower with a good credit score can easily obtain bank loans with minimal documentation. Banks usually ask for security in the form of collateral. Interest rates are generally less than 10%.
There are various modes of working capital finance provided by a bank. Some of them are:
A. Bank overdraft/cash credit limit: An overdraft or cash credit is an agreement with the bank wherein the account holder can withdraw an amount more than his balance up to a specific limit. Interest is charged only on overdrawn balance amounts daily.
B. Short term or long-term loans: Banks also provide a lump sum against security. The borrower must pay interest on the entire amount of the loan from the date of sanction of the loan.
C. Trade receivable financing: In this method, banks provide finance against the outstanding sale invoices of the company. They charge a service fee as well as discount charges for this facility. Trade receivable financing has a less complex lending process as businesses are not required to provide collateral or pre-existing loans with the lending institution. Alternative to this is the bill discounting facility.
(2) Non-banking financial institutions (NBFCs): NBFCs typically lend to MSMEs (Micro Small and Medium Enterprises) and mid rated corporates. Their lending rates vary from 9%-18%. NBFCs traditionally focus on providing loans to specified sectors. They also consider the credit rating of the customer before issuing a loan. They focus on the quick processing of loans and provide flexible repayment timelines. They cater to the specific business needs of the customers. They also provide bill discounting facilities.
(3) Informal lending: Private money lenders were the only source of finance before the establishment of commercial banks. They charge very high-interest rates, usually greater than 20%. They are local money lenders who provide loans to small traders or companies with no credit footprint. Any regulatory authority does not govern informal lenders. On the other hand, RBI has complete control over banks and NBFCs, making the lending process more formal and fair. The main motto of informal lending is to make profits by charging high-interest rates. Some of the informal lending sources are moneylenders, traders, friends, colleagues, etc.
(4) Advance from customers: One of the ways to raise funds to meet the working capital requirement is to get your customers provide payment in advance. It funds the order and provides much-needed cash to run the business. There is nominal or no interest payable to the customer for the advance money. Therefore, it makes this a cheapest source of raising funds for short-term working capital requirements provided the customers do not dictate the contract terms.
(5) Public deposits: Companies seek funds from the employees, shareholders and the general public as deposits against the issue of shares or debentures at relatively higher interest rates. It's main advantage is that it is one of the simpler and cheaper sources of working capital finance.
Going into a negative cash flow acts as an alarm against the growth of your business. By choosing the right mode of working capital finance, you can stay cash positive and focus on the growth of your business.
Working capital refers to the difference between a organisation's current assets and current liabilities. It acts as a good indicator of the liquidity and short-term financial health of a business.
The working capital example is as follows-
Regular Working Capital, Permanent Working Capital, Variable Working Capital, Reserve Margin Working Capital, Special Variable Working Capital, Seasonal Variable Working Capital, Net Working Capital and Gross Working Capital.
The two primary sources of working capital are the internal sources and the external sources.
The four primary components of working capital trade payables, account receivables, inventory, and cash and bank balances.