Any successful business needs two types of capital – fixed capital and working capital. The former is comparatively huge and is required to build the infrastructure of a company. The latter is the lifeblood of any business and is needed to keep the business moving smoothly. Some companies can manage their working capital by cutting down unnecessary expenses, but for many, working capital loan is the only way to keep steady cash flow.
Understanding The Working Capital
Working capital is the difference between the current assets and the current liabilities of a business.
Working Capital = Current Assets – Current Liabilities
The current assets are cash or any asset such as saleable inventory or receivable accounts, whereas, current liabilities are any debt owed by the business such as short-term loans or payable accounts.
Suppose, you have Rs. 10,00,000 worth current assets and Rs. 8,00,000 worth current liability. Then your working capital becomes,
Rs. 10,00,000 – Rs. 800,000 = Rs. 2,00,000.
The working capital is the measure of cash you are left with after you have accounted for your short-term liabilities.
Positive And Negative Working Capital
Ideally, your working capital should be positive, which is when your current assets are higher than your current liabilities. In this situation, you can quickly deal with your current liabilities, purchase inventory, and run business operations.
If the case is reversed, you will have negative working capital, which will make it difficult for you to pay your short-term debts, buy inventory, or run daily business operations. In a situation like this, the working capital loan becomes imperative.
How Much Working Capital You Need?
To know how much working capital is needed to run a business, use ‘working capital ratio.’ It also shows business efficiency and financial health of your business. This ratio is given as,
Working Capital Ratio = Current Assets / Current Liabilities
= Rs. 1,000,000 / Rs. 800,000
Ideally, the working capital ratio should fall from 1.2 to 2.0. If it is lower than 1.2, it means you have difficulties in paying your daily expenses on time. On the contrary, if this ratio is higher than 2.0, it means you are not investing enough in your company or new growth opportunities.
When To Consider Availing A Working Capital Loan?
We have seen working capital is used to manage daily expenses of a business. But, there can be many other reasons to consider getting working capital loans.
- Non-continuous Cash Flow: Your business cash flow will suffer if your customers do not pay you on time or your inventory takes a long time to sell. The working capital loan will help you mend your cash flow.
- Seasonal Sales Fluctuations: Working capital loans are of great help to take care of your business expenses during a slack period. It can even help you in buying the inventory to get ready for a new season.
- New Business Opportunity: It is unfortunate and quite frustrating to lose a business opportunity due to lack of adequate funds on time. Working capital loans can allow you to invest in a good project which may not have immediate pay-offs but which is profitable in the long run.
- Cash Cushion: Working capital loan can act as a cash cushion when you do not have sufficient cash flow to deal with emergency expenses.
Working Capital Loan Types
There are different types of working capital loans to choose from, depending upon your needs.
- Trade Credits: The present or potential supplier can offer it after checking your repayment history.
- Bank Overdraft Facility: You have to have good relations with your bank to an avail overdraft facility, which allows you to pay only the interest due on the overdrawn amount from the bank, the rate of interest, however, being higher than usual.
- Loan on the Bills Receivable: You can avail loan on the bills receivable based on the values of the confirmed sales orders. For this, you need to have a good credit history with the bank.
- Short-term Loan: It comes with a fixed rate of interest with a maximum repayment term of 24 months without any collateral security based upon your credit history and relationship with the loan lenders, such as NBFCs and banks.
- Equity Funding from Personal Resources: New businesses generally do not have a credit history with the bank. Therefore, equity funding is obtained from investors or private funds.
Advantages Of Working Capital Loans
Several public and private banks and non-banking financial companies (NBFCs) offer working capital loans. However, in the current scenario, consumers prefer NBFCs than banks to fulfil their financial needs. Let’s see why customers choose NBFCs over banks.
- Lending companies offer working capital loans at a faster rate than banks.
- The entrepreneur should be in business for at least five years to get loan approval from banks. This is not the case with NBFCs as they approve your loan even though the business is in operations for just two years.
- Many banks ask for collateral such as property, equipment, and receivables against the loan application. In such a scenario, you are not allowed to liquidate an asset if it is assigned as security to a bank. In the case of lending institutions, you will make a corporate guarantee on loan, but no amount will be assigned to it. This will give you the liberty to use your assets as and when needed.
- Working capital loans are extremely flexible than bank loans.
Rate Of Interest And Term Of Working Capital Loan
The rate of interest on working capital competitive than banks. Tenure of working capital is generally 12 months and comes with flexible collateral options.
Want to avoid negative cash flow that can kill your business? Working capital is the best bet in this scenario, considering all the advantages it offers. You can easily overcome short-term cash flow problems through working capital loans, which are relatively simple to obtain and protect your business from getting ruined.