Working capital is the money that is used by a business on a day to day basis. It is the money that is required for the day to day operations of a business. Without working capital, a business might not be able to operate efficiently, hence businesses might consider taking loans to meet this financial need. These loans that are used for the day to day operations of the business is known as working capital loan.
A working capital loan is not taken for the expansion of a business; it is taken for the exclusive purpose of conducting business operations on a daily basis. This means it covers the expenses of human resources and the expenses of existing capital.
1. What is a Working Capital Loan?
The concept of a working capital loan comes into picture when the business’s current liabilities outweigh the current assets. In such a case, the business has no other option other than to get a loan to cover the current liabilities and ensure that there is money to continue business operations. A working capital loan is a type of business loan that is used for the short-term financial goals of the business to meet its operational requirements.
Such a loan may not ensure long-term stability to the business but can ensure that the business is operational in the short-term. A working capital loan helps a business in taking care of short-term liabilities so that its long-term goals can be focused on and achieved accordingly.
Working capital loans are usually only applicable to small and medium enterprises and the usual period of the loan is 6-12 months. The interest rates for a working capital loan can range from 11-16% depending upon the lender.
2. Positive Versus Negative Working Capital
The way one calculates the working capital of a business is by deducting current liabilities from current assets. It is important to know what one’s working capital is to ascertain what needs to be done for business operations in the long-term as well as the short-term.
1. Positive working capital: In an ideal business, one should always strive to have more current assets compared to current liabilities. Positive working capital is when your current liabilities are lower than your current assets, this can ensure that one can pay off all business debts and still have the capital to invest in other resources for the business.
2. Negative working capital: Negative working capital is when one’s current liabilities are more than one’s current assets. This means that the business’s current debts cannot be completely paid off using only the current assets at hand.
3. Working Capital Ratio
A working capital ratio is a figure that is used to see the financial health of a business. Ideally, the working capital ratio should be between 1.2-2.0 to show that the business is doing well. A working capital ratio of 1.2 means that the business has enough current assets to cover its liabilities and to ensure day to day operations. Anything beyond a ratio of 2.0 means that the business is not investing its capital to further itself effectively.
The working capital ratio is computed by dividing current assets by current liabilities i.e.
Current assets/Current liabilities = Working capital ratio
For example, if the current assets of a company is worth Rs 2,00,000 and the current liabilities are Rs 1,40,000, the working capital ratio of the business would be:
2,00,000 / 1,40,000 = 1.42
4. Types of Working Capital Loan
There are many reasons why a person would be looking for a working capital loan. Depending upon what the need is, one should look at the different types of loans that are available.
- Short-term loan: This is a loan that comes with a fixed interest rate for 12 months. As long as the business has a good credit history, such loans can be obtained without the need of giving collateral.
- Accounts receivable loan: An account receivable loan is a loan taken out by a business to fulfil orders that have already been placed. Such a loan is easy to obtain as you already show the lender the pending orders to show that there will surely be cash flow from completing them.
- Bank overdraft: A bank overdraft is a type of working capital loan as the bank allows the business to overdraft their account when needed. The interest rate for such overdrafts is fixed and is usually higher than the prime rates of the bank.
- Trade creditor: This type of working capital loan is extended to the business by the creditors of the business; usually, the suppliers.
- Equity funding: This type of working loan is taken on by giving equity of the business to the lender. Of businesses that have a bad credit history or businesses that are just starting, hence having no credit history, this is the best option.
- Factoring loan: This type of loan works similar to accounts receivable loans. The difference lies with the credit in question. Where accounts receivable loans work on orders pending factoring loans work of the credit towards the business. For example, where a business accepts credit for products sold, the payments are still due on the sold items.
5. Advantages of a Working Capital Loan
There quite a few advantages in getting a working capital loan as compared to a regular business loan:
– No collateral needed
– Speed of acquisition
– No spending restriction
6. When Should One Get a Working Capital Loan?
There are many reasons why a business requires a working capital loan. The main purpose is to take care of short-term financial constraints of the business. There are lots of businesses that do not have a continuous and stable income throughout the year; hence they are sometimes unable to meet their liabilities. Here are some of the reasons a business should consider taking a working capital loan.
– Capitalization on investment opportunities: There may come a time for a business where they land upon an opportunity to further itself by investing in something. But in such a case, the business is unable to do so due to their financial situation; they should consider taking a working capital loan.
– Seasonal business: If a business is seasonal where they only have sales during a particular season, it means that the business does not have a stable cash flow throughout the year. This could lead to the business facing a financial crunch during their offseason, in such a situation, the best option is to get a working capital loan.
– Emergency cash reserve: If the business does not have enough financial stability to offer spontaneous financial for any purpose, it is a good idea to et a working capital loan to have something to fall back on in case of an emergency.
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