If you’re business is in a cash crunch and needs immediate cash to meet day-to-day expenses, a working capital loan will be ideal. Different businesses have different working capital needs depending on their overall business strategy and plan. To decide what kind of working capital your business might need keep in mind the nature of your business, its scale of operations, the time required to convert raw materials into finished goods, amount of sales made on cash and amount made on credit, demand based on the season, and emergency cash to meet contingencies. Before taking up a working capital loan understand your company’s liquidity position by calculating your working capital, which is current assets-current liabilities
Also don’t forget to make the following adjustments:
- Exclusion of cash commitments, like buy back of shares, and declared dividends from cash-in-hand.
- Removing non-trade receivables, like loans given to employees from the total value of debtors.
- Deducting old, wasted, and obsolete inventory from the total stock.
Then calculate working capital requirement based on your working capital ratio which is current assets divided by current liabilities (current assets/current liabilities). If this ratio is greater than 1 then your business has enough funds to manage day-to-day expenses. But a ratio of less than 1 means your business requires more working capital to ensure your business functions smoothly. Remember, a working capital ratio of 1.25 to 1.75 is financially healthy for a business to run efficiently.
Now that you understand the basics of working capital, let’s see the different types of working capital financing that your business can opt for depending on the above mentioned factors-
- Short-Term Working Capital Loans
As the name suggests these are usually taken for a short period i.e. less than 12 months and a fixed rate of interest is applied on them. The repayment schedule is also fixed and is typically 12 months.
- Cash Credit/Bank Overdraft
Both small and large businesses avail this facility from commercial banks to meet their working capital needs. Such a facility allows a business to withdraw a specific amount of cash that can be used for making business payments. But the borrower must ensure that they don’t cross the approved limit, just like a credit card limit. The pros of such a loan is that the rate of interest is only charged on the amount of cash actually used and not the approved amount. Such a loan is beneficial for a business that has seasonal demand and might need cash to meet sudden big orders.
- Trade Credit
Trade credit is the credit extended to a business by its suppliers who let them buy now and pay later. It is offered to businesses based on their creditworthiness which is reflected by their profit records, liquidity situation and payment history. Just like other funding methods trade credit has specific requirements and costs and the supplier only allows such a loan after thoroughly evaluating a business’ credit history.
- Bill/invoice discounting
In such a type of financing a business will provide its debtor bills to a lender and procure upfront cash for those bills. The lender will then collect the money on the date of maturity from the debtor and after deducting any charges it will return the money back to the business. Basically bill discounting/invoice discounting is an arrangement whereby a business recovers an amount of sales bill from a financial intermediary before it is due.
- Bank Guarantee
This is non-fund based working capital financing given by a bank to its client. A bank guarantee is a promise from a bank that the liabilities of a debtor will be met in the event that they fail to fulfil its contractual obligations. In short it guarantees to honour a payment to your beneficiaries upon receipt of a claim. It is used to decrease the risk of loss to the other party due to non- performance of agreed undertaking such as paying back money.
- Invoice factoring
This is often confused with invoice discounting but in this case a business sells all or some of its accounts payables to a third party at a value lower than the original value of those accounts. Then the third party (called the factor) collects the amount from the debtors and provides any remaining balance back to the business.
- Letter of credit
This is also a non-fund based working capital similar to a bank guarantee. A letter of credit is issued by a bank to another bank (especially one in a different country) to serve as a guarantee for payments made to a specified person under specified conditions. Businesses buy letter of credits to send to their suppliers.
The difference between a letter of credit and bank guarantee is that the former is a commitment taken on by a bank to make a payment to a beneficiary once certain criteria are met; whereas the latter is a bank’s commitment to honour a payment to a beneficiary if the opposing party does not fulfil its contractual obligations
- Equity Funding via Personal Resources or Investors
Here working capital funding is procured by selling equity to investors or friends and family. It’s mostly ideal for businesses that are just starting and don’t have a good credit history.