What are Working Capital Loans and Their Importance for MSME and SME Businesses

All businesses require considerable working capital to run their daily operations smoothly. It is required to pay employees’ salaries, plan payables cycles, and meet other operational expenses. However, when micro, small, and medium enterprises (MSMEs) follow non-optimal cash flow management practices, meeting working capital requirements can be a tall task. That’s where working capital loans come to a firm’s rescue.

So, what are working capital loans, and how do they enable MSMEs to manage their cash flows? Let’s understand.

What are Working Capital Loans?

Working capital loans are credit products that help small businesses meet their short-term expenses, such as salaries, rent, raw material procurement, etc. They are usually sachet-sized loans for a short duration, ranging from a few months to a year or two. 

Need for Working Capital Loans for MSMEs

Working capital loans can help MSMEs in meeting their short-term obligations successfully. We highlight some of the specific needs fulfilled by working capital loans below.

Cash Flow Management

Generally, MSMEs experience wide fluctuations in their cash flows. To illustrate, their capital may be temporarily blocked while procuring raw materials or in unsold inventory. Cash flow can also be an issue when the payables cycle is shorter than the receivables cycle. Thus, working capital loans ensure access to a steady funding source for covering short-term expenses, thereby ensuring financial stability.

Meeting Emergency Expenses

Unexpected events can put a huge strain on an MSME's financial resources. For instance, during COVID-19, 57% of the surveyed micro-enterprises did not have enough capital to survive during the lockdown, as per a six-month survey by the IGC. Thus, working capital loans can ensure a business’s survival during unfavourable circumstances. 

Growth Investment

Working capital loans provide small firms the financial resources to hire additional staff (beneficial for seasonal business models), expand operations, or even invest in new equipment. As a result, MSMEs can grow and become more competitive vis-à-vis their peers.

So, what are the various ways an MSME can avail of working capital loans?

Types of Working Capital Loans for MSMEs for Effective Cash Flow Management

Several types of working capital loans are available to MSMEs, which are listed below.

Invoice Factoring

Invoice factoring is a popular collateral-free working capital loan product under which MSMEs borrow capital against their outstanding invoices. Here, the enterprise sells its receivables to a factoring company and is extended a loan, typically amounting to 70-85% of the invoice value. It is especially suitable for firms engaged in seasonal businesses or those with poor credit histories.

Bank Overdraft

Banks generally extend an overdraft facility to businesses that have opened an account. In this working capital loan option, SMEs can borrow funds over the funds deposited in their account, subject to a fee. However, there is a fixed limit, which needs to be negotiated before the funds’ withdrawal.

Revolving Credit Lines

Credit lines are flexible working capital loans extended to MSMEs by several financial institutions. Under this loan product, small businesses can borrow any sum subject to a specified limit per their needs. Additionally, they must pay interest only on the amount borrowed, becoming extremely useful for businesses with fluctuating cash flow needs.

Short-Term Loans

Short-term working capital loans are small ticket-sized loans sanctioned for a tenure ranging between a few months and up to 3 years. These can be utilised for covering short-term expenses and are generally backed by collateral.

Trade Credit

Suppliers may offer working capital loans to MSMEs that place bulk orders with them through trade credit. It is an ideal option for MSMEs with a good reputation and creditworthiness. 

Merchant Cash Advances

A merchant cash advance is a type of working capital financing that affords businesses a lump sum in exchange for a percentage of their future credit card sales. It suits businesses with high credit card sales volume that require immediate funds.

Government-backed Loans

The Indian government runs several schemes for sanctioning business loans to MSMEs and startups, such as Working Capital Term Loans (WCTLs) for Contract Finance. Such loans usually carry favourable terms in the form of lower interest rates than traditional bank loans.

Bank Guarantee

While a bank guarantee does not specifically provide funds to a business, it enables MSMEs to cover the risk of a non-performance of an agreement. Banks offer such guarantees for a fee or against a pledged security.

But how can SMEs avail of working capital loans? Read on to understand the eligibility conditions that must be fulfilled to attain working capital loans. 

Eligibility Conditions and Required Documents 

Generally, working capital loans' eligibility criteria and documentation requirements differ across lenders and loan products. But there are some common eligibility criteria and documentation requirements that are applied to borrowers, which are listed as follows:

Eligibility Criteria for Working Capital Loans

• Applicant’s Age

An individual borrower must be at least 21 years of age at the time of working capital loan application. Additionally, the loan must mature before the applicant turns 65.

• Business Requirements

For availing of working capital loans, a business must be registered in India and have a valid permanent account number (PAN) and goods and services tax (GST) registration. It should also have an operational history of at least two years (it can be three for some.)

Additionally, the business must exhibit a healthy financial performance, as demonstrated by its financial statements and tax returns.

• CIBIL Score

The individual/business must have a good credit score (over 700+) and a solid, timely loan repayment track record.

• Collateral Requirements

Some financial lenders may demand collateral in the form of property, shares, machinery, or any other asset to extend a working capital loan.

Documentation Requirements for Obtaining Working Capital Loans

As mentioned above, the requirements commonly vary per lender. However, some of the general documentation requirements include

• A duly signed working capital loan application form
• Valid identity proof, such as an Aadhaar card/PAN card/Voter ID/Driving License/Passport
• Business registration proof, namely a registration certificate under the Shops and Establishment Act/Partnership deed
• Proof of address for a business along with PAN card/ GST certificate/Utility bills
• Previous 2-3 years’ financial statements and income tax returns 
• Prior six months’ bank statements 
• A business plan that outlines the purpose of the working capital loan and how it will be used
• Documents related to collateral’s ownership

As can be seen, obtaining a working capital loan can involve meeting stringent eligibility conditions, especially when sourced from banks. As a result, revenue-based financing models have been gaining popularity. Under these models, funds are provided to borrowers against a share of the company’s future revenues. 

So, how are working capital loans different from the revenue-based financing method? Let’s find out. 

Working Capital Loans vs Revenue-Based Financing for SMEs: Which is a Better Option?

Working capital loans and revenue-based financing are popular financing options MSMEs use to fund their operations. However, there are some major differences between these two financing options that firms should consider when deciding the most suitable option.

Hence the best option for an MSME will depend on its specific financial needs and circumstances. For instance, a revenue-based financing method will be ideal if a startup earns regular revenue but is yet to turn profitable. Similarly, firms with strong business models and credit history should prefer working capital loans.

Conclusion

Working capital loans are an important source of financing for MSMEs as they provide firms with adequate financial resources for meeting short-term financial obligations. Borrowers must carefully analyse and compare various working capital loans and their suitability to their business models.