Types of Working Capital and Working Capital Loans

What Is Working Capital?

Working capital is the money a business needs to run its daily operations. To find it, subtract current liabilities from current assets.

• Current assets are things you can turn into cash within a year. Examples are cash, stock and money owed by customers.
• Current liabilities are bills you must pay within a year. Examples are dues to suppliers and short-term borrowings.

A business with adequate working capital can meet its bills, buy raw materials and meet its payroll on time. It can also pay for unexpected expenses. Without it a business can shut down, even if it's making a profit on paper. This is what happens when customers are late paying, but your bills are due now.

Gross vs. Net Working Capital

Before looking at financing options, it helps to understand the basic accounting distinction between gross vs. net working capital.

Permanent vs. Temporary Working Capital

You can understand working capital needs through the lens of time. Understanding this distinction helps you make an informed decision and also helps you manage the funds according to the needs.

Types of Working Capital Loans

Once a business knows how much working capital it needs, it's time to choose the right financing option. There are different types of working capital loans available in India, each suited to different situations. Let's look at the most common ones.

1. Cash Credit

In India, cash credit is a very popular form of working capital financing. It's popular with small and medium businesses.

It is a secured cash facility, so you will need collateral. Generally, banks will determine your credit limit based on the value of your stock and receivables. You can withdraw money as you need it up to that limit. However, you only pay interest on what you spend, not the full limit. This is good for companies with variable cash needs.

The bank reviews the limit from time to time. It reviews how well your business has performed and the value of the security you have provided.

2. Bank Overdraft

A bank overdraft lets a business take out more money than it has in its current account. The business can do this up to a set limit.

It is similar to cash credit, but there are a few differences:

• Overdrafts are usually given against fixed deposits, property or other collateral.
• They are often more flexible to use.
• Interest is charged only on the overdrawn amount, and only for the days it stays unpaid.

An overdraft is a handy short-term fix for small, occasional cash shortfalls. Bank overdrafts also do not have fixed EMI obligations. The usage is adjusted from the amount you deposit in your current account. Many businesses find this more flexible as seasonal earnings can be used to settle this sooner. It is a revolving credit allowed by the banks. This means the amount you pay goes back into the bank overdraft and it gets full again.

3. Bill Discounting

In bill discounting, a business sells its unpaid bills or invoices to a bank or financial institution at a discount. It doesn't have to wait for the customer's due date. Later, the lender collects the full amount from the customer.

This helps businesses with long payment cycles keep their cash flow steady. It is best for small businesses since they sometimes have to wait for a long time to get paid.

4. Invoice Financing

Invoice financing is very similar to bill discounting. The business borrows money based on its outstanding invoices. In this, the business owner takes home the money. The lender usually offers 80-95% of the invoice value. Based on the structure, the customer will pay the business owner or the lender. The lender then releases the pending amount to the business owner.

This is a good solution for companies that have good customers that pay slowly. It releases cash trapped in receivables.

5. Revolving Facility

A revolving facility lets a business borrow, repay and borrow again, up to an agreed limit. You do not need to apply again each time.

Cash credit and overdraft are both common examples of revolving facilities.

The main benefit is convenience. When a short-term need comes up, you simply draw the funds. This suits ongoing needs that are hard to predict.

What Is Drawing Power?

If you have a cash credit or overdraft facility, you will hear the term drawing power.

Drawing power is the most you can withdraw from your approved limit at a given time. The lender works it out from the value of your current security, such as stock and receivables. It then applies a margin.

The drawing power is usually updated periodically, for example monthly, based on the most recent stock and receivables information released by the business. It's important to note that a business's actual sanctioned limit and its drawing power may differ. Even if your sanctioned limit is high, you can withdraw only up to your calculated drawing power at any point in time.

Term Loan vs Working Capital Loan

It's worth clarifying the difference between a term loan vs working capital loan, as the two serve very different purposes.

Whether you choose one or a combination of both options will depend on what your business actually needs the funds for and over what time frame.

How to Choose the Right Working Capital Option?

With so many types of working capital financing available, it helps to consider a few factors before deciding which one is best for your business:

• Nature of the funding gap: A long-term, ongoing need or a short-term, seasonal one?
• Cost of borrowing: Compare the interest rates and any processing fees applicable to each option.
• Speed of access to funds: Some facilities, like a revolving cash credit line, provide quicker access than applying for a fresh loan every time.
• Collateral available: Certain facilities like overdraft or cash credit may require collateral, while others such as invoice financing are more dependent on the strength of your receivables.
• Repayment flexibility: Think about the realistic time frame your business has to repay the borrowed amount, considering its cash flow cycle.

Conclusion

Effective management of working capital is essential for the smooth running of any business, whether it is understanding the difference between permanent and temporary needs or choosing the right financing option, from cash credit and bank overdraft to invoice financing and bill discounting. The right mix of options will depend on your business's cash flow cycle, the type of funding gap you have, and how quickly you need access to cash.

Want to learn more about working capital financing for your business? Get in touch with the team at Ambit Finvest to find a solution that works for you.

Frequently Asked Questions