Working Capital Loan: Benefits and Types

One of your main duties as an entrepreneur is to organize your company’s finances and ensure that you never run out of money for day-to-day operations. However, businesses occasionally find themselves in predicaments where they are unable to raise enough money to maintain their operations. A working capital loan is one of the greatest solutions to escape this situation.

What is a working capital loan?

A working capital loan is a loan provided to firms and businesses to help them with day-to-day operations. These are short-term loans that businesses use to pay for expenses such as payroll, rent, sales and marketing, among other immediate operating needs.

How working capital finance helps you?

The four most significant advantages of a working capital finance are listed below.

Handle immediate financial requirements

Working capital loans are an excellent way to temporarily top off a business’s cash reserves so that regular operations can continue without interruption. These loans assist the business in filling the gaps between client payouts and cash inflow, ensuring that all financial obligations are met on schedule.

Helpful for cyclical businesses

Many companies go through yearly cycles when demand for their products or services spikes around a particular time of year and then declines for the remainder of the year. Before the busy time begins, short-term working capital loans are a wonderful method to ensure that all financial obligations are satisfied, allowing the business to operate at full capacity and meet the increased demand without worrying about running out of money.

Freedom on expenditure

Working capital loans don’t place restrictions on the borrower’s use of the funds, in contrast to the majority of other loans. This indicates that the borrower has complete discretion and freedom to use the funds anyway they see fit for the benefit of the company. 

Owners have full control over the company

Working capital financing is a type of debt financing that has no effect on a company’s equity, allowing the owner to access funds without giving up any ownership interest in his business.

Types of working capital loans

There are several different kinds of working capital loans accessible to firms in India.

Working capital term loan

The simplest type of loan is a term loan, where the lender gives the applicant the approved amount after carefully considering their ability to repay the debt. The loan must be returned with interest in a set number of equal monthly payments. Most of these loans are secured and demand some kind of security. However, if the lender is pleased with the applicant’s creditworthiness and ability to continue doing business, they may also approve the loan without any collateral.

Bank guarantee

The seller or buyer obtains a bank guarantee to offset the potential risk associated with the failure to fulfill under a specific agreement. Anything from a payment to a promise of services could qualify. Only when the other party fails to perform does the holder repeal it. The supplier and buyer can conduct their business dealings with the security of getting the payment and goods when a bank guarantee is included in the trade transaction. Since the loan is not based on the availability of funds, having a bank guarantee only serves as a promise that the supplier will get paid provided he fulfills the terms of the contract with regard to delivery of the goods. For this service, the bank requests certain security and charges a commission.

Bill discounting

By using bill discounting, you can get money in advance from a lender in exchange for confirmed sales orders. A seller who is low on cash and who has sold items to one or more customers but has not yet received payment may be able to sell those unpaid bills to a lender at a discount. The lender issues the cash to the vendor right away after subtracting some money for interest. When the buyer’s payment is due, it takes payment in full from them.

Letter of credit

A business can seek a Letter of Credit (LC) from a lender if it needs a working capital loan to complete a transaction (banks or NBFCs). The buyer may submit the letter to the supplier in lieu of payments once the lender approves it. The supplier can take this Letter of Credit to a bank or other financial institution to “discount” the LC and have the funds sent to him after interest has been deducted if he needs to access the money immediately. Within the set time frame, the buyer must pay the lender the amount secured by the LC.

Invoice factoring

One of the quickest and simplest ways to reduce the negative effects of unpaid accounts receivable on your cash flow is through invoice factoring. The business can sell its invoices or accounts receivable to a factoring company under the terms of invoice factoring. When the factoring business gets payment from the buyer on the due date, it promptly pays 80–90% of the invoice value to the supplier and the remaining funds are transferred after deducting interest. As it gives suppliers and buyers more freedom to conduct business, invoice factoring is one of the simplest working capital solutions for any trade transaction that includes a specific credit period as part of the payment terms. Suppliers can also acquire finance through invoice factoring in addition to their existing bank credit line since it is an off-balance sheet source of funding.

Trade credit/Line of credit

Trade credit is an agreement between commercial entities whereby the supplier grants the recipient access to a line of credit, meaning that payment for the goods may be made at a later date. These trade loan terms range from 30 to 90 days. But with certain companies, trade credits are granted for a longer time. The recipient’s creditworthiness is crucial in this situation.

Cash credit and overdraft

The two types of working capital loans that are most frequently used are cash credit and overdrafts. Here, a bank or other lender creates an account and authorizes a cash loan up to the company. The borrower is permitted to withdraw any amount of money from this account up to the lender’s set limit. For these loans, the interest is only charged on the actual amount borrowed, not the maximum. 

Even though Cash Credit and Overdrafts are the most popular working capital products, it is challenging for the majority of Indian SMEs to obtain them because banks often demand substantial collateral and well-organized financials for loan approval. Additionally, the banks’ financial authorizations or working capital restrictions may not be sufficient to meet the company’s working capital needs.

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