Working Capital Loan

A working capital loan is a loan that is taken to finance a company's everyday operations.
These loans are not used to buy long-term assets or investments and are, instead, used to
provide the working capital that covers a company's short-term operational needs. Those needs
can include costs such as payroll, rent and debt payments. In this way, working capital loans
are simply corporate debt borrowings that are used by a company to finance its daily operations.

Working of working capital Loan

Sometimes a company does not have adequate cash on hand or asset liquidity to cover day-to-
day operational expenses and, thus, will secure a loan for this purpose. Companies that have
high seasonality or cyclical sales usually rely on working capital loans to help with periods of
reduced business activity.

Many companies do not have stable or predictable revenue throughout the year. Manufacturing
companies, for example, have cyclical sales that correspond with the needs of retailers. Most
retailers sell more product during the fourth quarter – that is, the holiday season – than at any
other time of the year.

To supply retailers with the proper amount of goods, manufacturers typically conduct most of
their production activity during the summer months, getting inventories ready for the fourth
quarter push. Then, when the end of the year hits, retailers reduce manufacturing purchases as
they focuses on selling through their inventory, which subsequently reduces manufacturing
sales.

Manufacturers with this type of seasonality often require a working capital loan to pay wages
and other operating expenses during the quiet period of the fourth quarter. The loan is usually
repaid by the time the company hits its busy season and no longer needs the financing.

Missed payments on a working capital loan may hurt the business owner's credit score if the
loan is tied to their personal credit.
Types of financing include a term loan, a business line of credit or invoice financing, a form of
short-term borrowing that is extended by a lender to its business customers based on unpaid
invoices. Business credit cards, which allow you to earn rewards, can also provide access to
working capital.

Pros and Cons of a Working Capital Loan

The immediate benefit of a working capital loan is that it's easy to obtain and lets business
owners efficiently cover any gaps in working capital expenditures. The other noticeable benefit
is that it is a form of debt financing and does not require an equity transaction, meaning that a
business owner maintains full control of their company, even if the financing need is dire.

Some working capital loans are unsecured. If this is the case, a company is not required to put
down any collateral to secure the loan. However, only companies or business owners with a
high credit rating are eligible for an unsecured loan. Businesses with little to no credit have
to securitize the loan.
A collateralized working capital loan that needs asset collateral can be a drawback to the loan
process. However, there are other potential drawbacks to this type of working capital loan.
Interest rates are high in order to compensate the lending institution for risk. Furthermore,
working capital loans are often tied to a business owner's personal credit, and any missed
payments or defaults will hurt his or her credit score.

Working Capital Financing

Working capital financing is done by various modes such as trade credit, cash credit/bank
overdraft, working capital loan, purchase of bills/discount of bills, bank guarantee, letter of
credit, factoring, commercial paper, inter-corporate deposits etc.

The arrangement of working capital financing forms a major part of the day to day activities
of a finance manager. It is a very crucial activity and requires continuous attention because
working capital is the money which keeps the day to day business operations smooth. Without
appropriate and sufficient working capital financing, a firm may get into troubles. Insufficient
working capital may result in nonpayment of certain dues on time. Inappropriate mode of
financing would result in loss of interest which directly hits the profits of the firm.
Types of Working Capital Financing / Loans
Trade Credit
This is simply the credit period which is extended by the creditor of the business. Trade credit
is extended based on the creditworthiness of the firm which is reflected by its earning records,
liquidity position, and records of payment. Just like other sources of working capital financing,
trade credit also comes with a cost after the free credit period. Normally, it is a costly source
as a means of financing business working capital.

Cash Credit / Bank Overdraft

Cash credit or bank overdraft is the most useful and appropriate type of working capital
financing extensively used by all small and big businesses. It is a facility offered by commercial
banks whereby the borrower is sanctioned a particular amount which can be utilized for making
his business payments. The borrower has to make sure that he does not cross the sanctioned
limit. The best part is that the interest is charged to the extent the money is used and not on the
sanctioned amount which motivates him to keep depositing the amount as soon as possible to
save on interest cost. Without a doubt, this is a cost-effective working capital financing.

Working Capital Loans

Working capital loans are as good as term loan for a short period. These loans may be repaid
in installments or a lump sum at the end. The borrower should take such loans for financing
permanent working capital needs. The cost of interest would not allow using such loans for
temporary working capital.

Purchase / Discount of Bills

For a business, it is another good service provided by commercial banks for working capital
financing. Every firm generates bills in the normal course of business while selling goods to
debtors. Ultimately, that bill acts as a document to receive payment from the debtor. The seller
who requires money will approach the bank with that bill and bank will apply the discount on
the total amount of the bill based on the prevailing interest rates and pay the remaining amount
to the seller. On the date of maturity of that bill, the bank will approach the debtor and collect
the money from him.

Bank Guarantee
It is primarily known as non-fund based working capital financing. Bank guarantee is acquired
by a buyer or seller to reduce the risk of loss to the opposite party due to non-performance of
the agreed task which may be repaying money or providing of some services etc. A buyer ‘B1’
is buying some products from seller ‘S1’. In this case, ‘B1’ may acquire bank guarantee from
the bank and give it to ‘S1’ to save him from the risk of nonpayment. Similarly, if ‘S1’ may
acquire bank guarantee and hand it over to ‘B1’ to save him from the risk of getting lower
quality goods or late delivery of goods etc. In essence, a bank guarantee is revoked by the
holder only in case of non-performance by the other party. Bank charges some commission for
same and may also ask for security.

Letter of Credit
It is also known as non-fund based working capital financing. Letter of credit and bank
guarantee has a very thin line of difference. Bank guarantee is revoked and the bank makes
payment to the holder in case of non-performance of the opposite party whereas, in the case of
a letter of credit, the bank will pay the opposite party as soon as the party performs as per
agreed terms. So, a buyer would buy a letter of credit and send it to the seller. Once the seller
sends the goods as per the agreement, the bank would pay the seller and collects that money
from the buyer.

Factoring
Factoring is an arrangement whereby a business sells all or selected accounts payables to a
third party at a price lower than the realizable value of those accounts. The third party here is
known as the ‘factor’ who provides factoring services to business. The factor would not only
provide financing by purchasing the accounts but also collects the amount from the debtors.
Factoring is of two types – with recourse and without recourse. The credit risk of nonpayment
by the debtor is borne by the business in case of with recourse and it is borne by the factor in
the case of without recourse.

Some other sources of working capital financing used are inter-corporate deposits, commercial
paper, public deposits etc.

There are different types of working capital financing available in the Indian market, such as
Cash credit/Bank overdraft, trade credit, purchase of bills/discount of bills, working capital
loan, bank guarantee, invoice factoring, and letter of credit.

Working capital management outlines a major part of the daily activities of an Entrepreneur.
This activity is very important and requires attention because working capital maintains the
daily business operations smooth. Without appropriate working capital financing, a small
business can also get into difficulties. Inadequate working capital can also result into
nonpayment of certain dues on time. Improper type of funding would cause loss of interest
which directly hits the profits of the business.

Here are the different types of working capital financing;

Cash Credit/Bank Overdraft

These are the most usable forms of working capital financing that are mainly used by both
small and large businesses. These cash facilities are provided by the commercial banks by
which the borrower is approved a specific amount of cash that he can use for making business
payments. Additionally in this setting, the borrower has to make certain that he does not cross
the approved limit. The good thing is that the rate of interest is charged to the level the cash is
used and not at the approved amount which encourages him to keep depositing the amount
when possible to save on interest rate. Truly, this is valuable working capital financing.

Trade Credit

This is a type of working capital financing that is extended by the present or potential supplier
of a business. Trade credit is offered to businesses based on their creditworthiness, which is
revealed by its profit records, liquidity situation and payment records. As other funding
programs, trade credit also comes with some specific requirements and costs. The supplier will
also thoroughly evaluate your business credit history before offering you money.

Purchase/Discount of Bills

For a small business, it is another good type of working capital financing provided by the
commercial banks. Every business generates bills in their normal routine while selling products
or services to debtors. In the end, that bill works as a document to get payment from the debtor.
And if the seller needs cash, he will go directly to the bank with that bill and the bank will
apply discount on the whole amount of the bill primarily based on the existing interest and pay
the outstanding amount to the seller. The bank will collect the money on the maturity date of
that bill.

Working Capital Loans

Working capital loans are used by small businesses to finance their day by day operations or
raise their cash flow. Working capital loans are as good as term loans for a short duration.
During financial difficulties, a small business can get help from this loan to pay for salaries,
mortgages, rent and other expenses. You can also get this loan for financing your business
permanent working capital requirements.

Bank Guarantee

This is a non-fund based working capital financing. Bank guarantee is acquired by the client
or seller to decrease the risk of loss to the other party due to non- performance of agreed
undertaking which may be paying back the money or offering some services and so on. A bank
guarantee is repealed by the holder only in case of non-performance by other party. Bank will
charge some commission and may also ask for some security.

Invoice Factoring

Invoice factoring is an arrangement in which a business sells all or some of the accounts
payables to a third party at a value lower than the original value of those accounts. The third
party in this setting is called the factor that offers factoring services to business. The factor
provides financing by purchasing the bills and additionally collects the amount from the
debtors.

Letter of Credit

This form is also known as non-fund based working capital financing. There is a little
difference between letter of credit and bank guarantee. So, a buyer would purchase a letter of
credit and send it to the seller. As soon as the seller sends the products according to the
agreement, the bank would pay the amount to the seller and collects that cash from the buyer.