A business needs money to pay off its regular monthly bills, purchasing equipment, machinery, inventory, tools, fixed and personal assets, raw materials, property and office premises, trademarks and even consultation and guidance. All of this has to be in perfect balance along with carrying out the daily operations, maintaining the operating capital and having enough liquid cash for other labor and personal expenses. A business starts with either a small or large amount of capital depending upon the type of business and the model on which it has been established in the first place. At a point, it also needs to expand or modernize according to the changing and diversified consumer tastes, behaviors and purchasing habits. Firms need enough inflow of cash to run their business smoothly and that is where the need for working capital loan arises.
Realizing the Need for Working Capital Finance
Carrying out business operations can require proper analysis of earnings, expenditures, profits, losses, inflow and outflow of cash. A business needs to understand how these aspects affect a firm’s funding abilities and the steps they need to keep that in control. For that, they need to evaluate and analyze their financial statements like balance sheets and P&L accounts to be able to find the gaps which are required to be filled. This evaluation will guide you with the amount of funding you need.
What is Working Capital?
Most of the times, a firm might be earning continuous profits and still not able to maintain proper cash flow or raise working capital. Working capital is required for paying all your daily business expenses. Reading the relevant statements can help you decide on what amount of working capital you might need. Working Capital Loans are primarily purchased for meeting financial needs like daily wages, accounts payable and other related expenses. These loans are unsecured and businesses can buy them for short durations. The tenure and interest rates applicable to these loans vary from one lender to another.
When Can a Working Capital Loan Be Availed?
These loans are based on current orders or the invoices that are yet to be paid. Hence, they cannot be purchased for an amount which is not payable by a firm. This removes the risks associated with not being able to pay it back. If a business has a decent record of credit, it qualifies for buying such a loan. Also, these types of loans don’t have any security against them. Working capital loans cover everything from machinery loans, accounts receivables, lines of credit for short durations. They have the repayment flexibility which makes it even more customer-friendly.
Different Types of Working Capital Loans
Loans purchased for maintaining the liquidity of cash and meet operational expenditures depend on the needs and preferences of a business. These can be bought in the following ways:
Bank Overdraft is also called Cash Credit. This facility is availed by most of the businesses wherein; the purchaser avails a specific amount for utilizing it to pay for operating payments. The rates of interest and line of credit depend on a firm’s relationship with the lending authority.
Moreover, the businesses have to pay the interest only on the amount which is utilized by it, instead of the whole amount. It is the most cost-efficient solution as the borrower keeps on depositing the amount as and when he employs it, to save the interest cost.
Also Read: How to Apply for Overdraft Facility
Accounts Receivable Financing
Accounts receivable financing is also a type of working capital loans for the businesses which need financing for a sales order received by it and needs to make payments for providing the deliverables. Accounts receivable financing is only for the sales orders which are confirmed but, the firm is unable to gather the required fund to pay for it. However, businesses must have an excellent record of credit for borrowing this loan.
These loans are quite similar to accounts receivable financing. However, there is one difference between the two that the amount of the loans is based on future credit receipts. It is a process of arranging some chosen accounts payable and selling them to the party who provides funding to the business. The accounts payables are sold at a decreased amount than their actual value. The “factor party” here also collects the amount from the debtors of the company whom it is financing. This loan is either with recourse or without it. In the case of recourse, the risks are borne by the firm if debtors don’t pay the amount. Whereas, the risk is taken by the factor party if it is without recourse.
A current or prospective supplier offers this type of working capital finance as trade credit. In simple terms, it is the extension of the credit period by that supplier. The expansion depends on a company’s liquidity position and payment history. The supplier checks a firm’s record of credit and how capable it is to pay off the money before he extends the period or offers trade credit loan. As the free period of credit ends, the trade credit charges a nominal fee. These are usually issued when a company places a bulk order with them.
One of the most common operations of a business is – generating bills on sales. The statements are the proof or a verified document which are produced in front of debtors by a firm, to get the required money the debtors owe them. Banks provide this facility to these firms by offering them an amount after adding a discount on the amount of that bill on the bank interest rates. The remaining amount would be paid back to the seller. As the bill matures, the bank would collect that discounted money from the debtor.
Bank guarantee refers to the financing responsibilities of a bank which are not based on money or any types of funds. A firm can acquire it for decreasing the number of risks that can arise due to any third party. The risks can either be about the non-payment on the part of the third party or receiving any services. However, this guarantee can only be bought by a seller when there is a non-performance of any of these tasks. A minimal commission is charged by the bank in addition to some collateral.
Letter of Credit
Letter of Credit is another type of working capital finance similar to Bank Guarantee, acquired by a borrower. The difference in both forms of loans is that; in Letter of Credit, as and when the opposite party delivers according to the defined terms the bank will pay for it. Hence, a borrower would purchase a Letter of Credit which would be sent to the seller with some terms and conditions written on it. As the seller performs the services according to the agreement, he would get the money by the bank and the purchaser would pay his dues to the bank.
As the name suggests, these loans have a fixed rate of interest and a definite duration of repayment. The period generally is up to one year and comes with collateral security attached to it. It also depends on the type of relationship a firm has with the lending authority. Hence, if a company has a record of excellent credit, it might get this loan which can be paid minus any security.
This type of working capital loan is typically borrowed from a business’s investments like investors, friends and family or home equities. This is an excellent option for the businesses who are just initiating their operations. Moreover, it can be the most realistic solution for paying off bills and raising capital as initially, a company won’t be having a credit record.