Working capital simply refers to the funds or money needed to manage the daily operations of a business. All types of business, small or large, corporate or family-owned, often fall short of working capital as most transactions are done on credit, many extending for months before the dues are realised. In these circumstances, businesses may not have enough liquidity to meet their short-term obligations. This is where working capital loans can bail them out by bridging the funding gap to provide short-term loans facilities with collaterals.
However, there are various types of working loans that are offered by banks to meet the various kinds of needs of businesses. Here are some of the most common ones available:
Cash credit: Cash credit is one of the most widely used working capital loan types. This facility is provided against the pledge or hypothecation of stock-in-trade, such as raw materials, finished goods, work-in-progress, or against receivables from debtors or even against property, shares, etc. The borrower can withdraw over and above the balance maintained in the cash credit account but only up to a pre-specified limit. The interest is charged on the limit utilized and not the sanctioned limit. You will need to open a separate account for availing this facility.
Overdraft: The overdraft facility is available to current account holders for withdrawing money, more than what’s available in their current account. This facility is usually offered to high-value current account holders, who usually keep substantial deposits and have a long-standing relationship with their banks. The overdraft limit is determined on the basis of the collaterals provided, which are usually fixed assets. For example, Axis Bank offers an overdraft facility of up to Rs 3 crore to businesses having a turnover of Rs 30 lakh to Rs 10 crore with LTV ratio of up to 100%. The interest is charged on the overdraft amount utilised till its repayment.
Bill Discounting: This is a fund-based working capital arrangement under which the bank purchases a bill or invoice drawn by a seller/supplier and pays it immediately after deducting some amount from the bill as a discount or commission. The bank then presents the bill to the purchaser on or after its due date and collects the bill amount directly. In case the payment gets delayed, the bank charges a pre-determined penal interest from the supplier. Bill discounting forms a major component in working capital finance as it helps bridge the fund gap between the date of sale and the due date of receiving the payment.
Bank guarantee: A bank guarantee is an undertaking from a bank that if a purchaser fails to make repayments or honour other commitments to its vendor. The bank, in this case, will compensate the vendor on the purchaser’s behalf. For example, assume that a relatively lesser known ‘Company A’ wants to make a large purchase from a well-established ‘Company B’. If Company B is unsure of the Company A’s capacity to pay the bill, it will ask Company A to produce a bank guarantee. Company A will approach its lender for a bank guarantee, which will be issued in lieu of commission and collaterals. In case, the Company A fails to pay Company B for the purchase, the latter will notify the former’s lender and receive the amount mentioned in the bank guarantee. Thus, bank guarantees allow businesses to make purchases that they are otherwise not able to, while simultaneously reducing the vendors’ credit risk.
Letter of Credit: Letter of credit (L/C) is a non-fund based working capital arrangement used to indemnify the sellers from credit risk. It is mostly used in international trade where a supplier might not be known to the importer and the difference in jurisdictions further increases the credit risk. Just as in the case of bank guarantees, the banker of the importer will issue an L/C in favour of the exporter, who on the strength of the L/C feels reassured in exporting the goods to the importer. Once the goods are supplied, the exporter will directly present the L/C to the issuing bank and receive the payment. Banks usually issue L/C in lieu of immovable properties as collaterals and charge a percentage of the L/C amount as fees. For example, ICICI Bank offers L/Cs against 100% cash margin in the form of bank fixed deposits.