Working capital is the money used to run the day-to-day operations of a business. These could be rent, salaries, utilities, the purchase of raw materials, and other expenses. It is calculated as the difference between current assets and liabilities. Working capital reflects a company’s liquidity level and financial health. Without it, a business might not function smoothly. As a result, businesses often take out working capital loans to keep their operations running. These loans are not used for investments or buying long-term assets, but to meet the company’s short-term operational needs.
What is a Working Capital Loan?
Businesses don’t generate revenue throughout the year. There are ups and downs in sales. And some businesses are seasonal. However, they need to keep the operations running. There might not be enough cash on hand or liquid assets. Hence, they require working capital. For this purpose, they secure a working capital loan. It helps during low sales and revenue periods.
Banks and other financial institutions offer working capital loans to keep businesses going. The loans can be secured or unsecured. The repayment period is usually flexible, with a tenure that ranges between 6 and 48 months. The loan amount, interest rates, and tenure may vary from lender to lender. Not just that, working capital loans are of multiple types. Let’s have a look at its various types.
Types of Working Capital Loans
- Cash Credit
Cash credit is a short-term solution for working capital financing. It is a secured loan. Hence, collateral needs to be pledged. It can be stock-in-trade, assets, work-in-progress, finished goods, etc. It is necessary to open a separate cash credit account in order to take advantage of the facility. Cash credit lets you withdraw money without keeping a credit balance. You can withdraw more than the balance maintained in the account. The interest is charged on the daily closing balance or the used limits, not the amount sanctioned.
- Overdraft Facility
The overdraft facility lets a current account holder withdraw more cash than what is available in their accounts. The overdraft limit and time period depend on the provided collateral. People who have a good credit history and a long-term relationship with the bank are generally preferred. Interest is charged on the amount drawn until repayment.
- Bill Discounting
Bill discounting is a financial tool where a bank buys the bills or invoices of the seller. The bank pays the borrower the bill amount after deducting a commission or discount. Later, on or after the due date, the bank presents the bill to the purchaser and collects the bill amount directly from them. This method is most commonly used by traders, manufacturers, wholesalers, and businesses engaged in transport and logistics.
- Bank Guarantee
A bank guarantee is offered by banks or lenders in lieu of collateral or commission. It is to ensure that in the event a debtor is unable to repay their debts, the bank will take care of the losses.
For example, Company 1 wants to make a large purchase from Company 2. But Company 2 is unsure of the payment capacity of Company 1. So, Company 2 asks Company 1 to issue a bank guarantee regarding the payment. Company 1 will approach their lender for a bank guarantee. This will state that if Company 1 cannot make the payment by the due date, then Company 2 can seek payment from the lender of Company 1.
- Letter of Credit
A letter of credit is a financial document generally used in international trade. It lets the two parties do business without worrying. It assures that if the borrower cannot pay the debt of another party, the lender will take care of the credit. Letters of credit serve as security, while bank guarantees act as insurance.
- Accounts Receivable Loan
Accounts receivable loans are a way to raise funds for issued invoices. A business uses its accounts receivable as collateral to raise funds from a bank. Accounts receivable is the amount for which the invoice has been submitted but the payment has not yet been made. These loans are usually provided to businesses with a good sales reputation and a healthy credit history.
Benefits of Working Loan Capital
Working with loan capital comes with many benefits. Some of these include:
- There is no restriction on using the funds.
- The loans are easy to secure, and the disbursement is quick. This makes them a great option for immediate financial needs.
- Some types of working capital loans are unsecured and can be issued without collateral.
- Flexible tenure and reasonable interest rates.
Working capital loans are a great option to meet your day-to-day business needs. Some of them are unsecured, which doesn’t require collateral. The loans can be taken easily, and the money is quickly disbursed. This helps in providing sufficient liquidity for reducing short-term obligations. Working capital loans also help in maintaining cash reserves and managing sales fluctuations.
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