There are times when companies do not have enough resources to carry out day-to-day expenses and might have to rely on loans to survive. During such times, people apply for a working capital loan.
What is a working capital loan?
A working capital loan is a debt the company uses to perform daily activities such as rent, debt payments, and payroll. The loan is for short-term needs and not meant for long-term assets or investments.
The business owner’s credit score may get affected as working capital loans are linked to their credit.
Let’s understand the scenario between manufacturers and retailers, retailers do not have a constant or expected revenue throughout the year and will have to rely on a business loan. There are times when retailers sell more products during the holiday season than at any other time of the year.
Manufacturers with this kind of working model often require a working capital loan to pay wages and other operational activities. The loan is usually repaid during the company’s busy season and no longer needs the financing.
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Types of Working Capital Loan:
Here are different types of working capital loans which will help you understand more about them
Cash Credit(CC)/Bank Overdraft:
Cash Credit (CC) is a short-term loan granted to companies to meet their working capital requirements. On the other hand, a Bank Overdraft loan is long-term assistance offered by banks to individuals or companies to withdraw money even with zero balance.
Cash Credit and Bank Overdraft may seem similar but have different purposes. The purpose of CC is to help customers buy raw materials, take care of receivables, and maintain stocks, and bank overdraft aims to keep business operational.
The point where both small and large businesses focus is the rate of interest. In CC, the rate of interest is calculated on the amount withdrawn, and in bank overdraft rate of interest is based on the amount used by the customer.
A Bank guarantee comes into the picture when any borrower or lender fails to repay the loan, the bank or financial institution will take care of the losses.
Parties involved in Bank Guarantee:
- Applicant: The customer who requests a bank guarantee and requests a loan from the creditor
- Beneficiary: The person that receives a partial guarantee.
- Bank: A financial institution that agrees to sign and assures complete payment in case the applicant fails to repay.
- The applicant requests a loan from the beneficiary or creditor.
- Both the parties agree that a bank guarantee is required to progress the loan formalities.
- The applicant requests the bank to sign and assure a bank guarantee
- The bank now offers a bank guarantee and may charge some commission or ask for a security amount.
Letter of Credit:
MSME full form is (Micro, Small, and Medium Enterprise) loans aim to help companies fund their working capital necessities and other expenses like raw material, purchase of machinery, and fixed assets.
Letter of Credit is a non-funding working capital loan. It is similar to a bank guarantee loan type, but here the bank issues a letter of credit, and in case of non-payment by the applicant, the bank is responsible for the complete payment.
It is a document where the bank promises that the seller will receive the agreed amount from the buyer without any delays. The bank will charge a fee, a percentage of the letter of credit, by offering the letter of credit.
Invoice Factoring is a short-term loan that is also known as “receivables financing.” Let’s dig deeper into receivables financing.
When manufacturers sell goods or services to large customers, such as wholesalers or retailers, they do so on a credit basis. It indicates that the customer does not have to pay immediately for the goods that it purchases. An invoice with the amount due and bill due date is submitted to the buyer.
Now manufacturers also have to look for their day-to-day operational needs and pay wages to workers. To support slow-paying accounts receivable or to meet short-term needs, companies opt to finance their invoices.
Working Capital Loans:
Working Capital loan is an initiative to help entrepreneurs and encourage them to establish SMEs and MSME.
CGTMSE (Credit Guarantee Fund Trust for Micro and Small Enterprises) is an initiative to help meet the financial needs of MSME. It is a trust which provides credit guarantees to financial institutions that thereby help entrepreneurs.
The rate of interest in CGTMSE is comparatively low and calculated upon the customer’s profile, business requirements, and project cost.
Purchasing/Discount of Bills:
Another good working capital for SMEs is Purchasing/Discount of Bills.
As we all know, the bill plays an important role in the purchase of goods and services. In this type of working capital loan, that bill serves as a document to receive payment from the debtor.
In case the seller needs cash, he approaches the bank with the bill that then applies a discount on the whole amount of the bill.
The discount is primarily based on the existing interest and the outstanding amount is paid to the seller.
It is a B2B agreement wherein customers do not have to pay the amount upfront while purchasing goods/services. The buyer pays the amount to the supplier later on the scheduled date.
Consider trade credit as 0% financing, which improves the company’s financial condition in exchange for goods and services. It is an advantage for the buyer, that helps a business to purchase, manufacture, and sell goods before paying for them.
This process supports companies/buyer’s to receive a revenue stream that can cover the costs of goods sold.
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Frequently Asked Questions
1) Temporary Working Capital
2) Permanent Working Capital
3) Gross & Net Working Capital
4) Negative Working Capital
5) Reserve Working Capital
6) Regular Working Capital
7) Seasonal Working Capital
Components of Working Capital:
1) Current Assets
2) Cash and Cash Equivalents
3) Account Receivables
5) Accounts Payable
The goal of working capital management is to maximize operational efficiency. Efficient working capital management helps maintain smooth operations and can also help to improve the company’s earnings and profitability.
The working capital ratio is calculated simply by dividing total current assets by total current liabilities. For that reason, it can also be called the current ratio. It is a measure of liquidity, meaning the business’s ability to meet its payment obligations as they fall due.