Learn About Working Capital Loans - Business Loan Blog - Tata Capital

Ever wondered what a working capital loan is?

Mar 07, 2017

Meet Rajesh, an entrepreneur who has been running his business for the past five years. Rajesh's enterprise requires around Rs. 1 lakh per month for operational expenses like salaries, supplier payments, office expenses, etc. Rajesh knows that April to June is a slow quarter, where monthly revenues rarely exceed Rs. 25,000. Rajesh also knows that the general demand is high and that the firm's annual income can easily cross Rs. 25 lakhs.

If Rajesh was to rely solely on business revenues to meet his expenses, then the Rs. 2.25 lakh shortfall between April and June would likely wreck his business. Suppliers would remain unpaid, salaries would get delayed, and the office would lose power due to non-payment of electricity bills for three months. Due to those three lean months, he would be out of business, despite the fact that the next quarter would solve all the problems.

This is where working capital loans come into play.

Related: 5 myths business owners must not believe about business loans

What Are Working Capital Loans?

As the termsuggests, these loans provide capital to keep a business running without any short-term funding issues. An Overdraft (OD) of Rs. 1 lakh combined with a Cash Credit (CC) limit of Rs. 6 lakhs will help Rajesh meet the Rs. 2.25 lakhs shortfall between April and June.

Revenues earned between July and September will then be used to clear the loan and replenish the limit. Working capital loans help firms resolve liquidity issues and cyclical variations in revenues without any hassles or complications.

Types of Working Capital Loans

These loans can be classified into three categories:

  • Overdrafts
  • Cash Credit Accounts
  • Non-Fund Facilities for Letters of Credit, Bank Guarantees etc.

Overdrafts are utilised for meeting daily routine expenses like the office electricity bill, consumables, stationery, purchase of minor equipment, and so on. This credit facility is normally linked to the firm's Current Account.

CC account is a credit facility granted against collateral like hypothecation of goods or any other physical assets. Generally, the limit is significantly higher than an OD limit and businesses use accumulated revenues to repay the loan and renew the limit at least once in a year. The CC limit is normally used to pay important recurring expenses like salaries, utility bills, taxes, and creditor dues.

Related: 5 steps to your successful start-up

Non Fund facilities can be used to pay for deposits, guarantees, and letters of credit that are normally required by clients as additional security, pending completion of the contract. A guarantee of Rs. 10 lakhs may help Rajesh win a big overseas order worth Rs. 1 crore. However, taking such a big amount out of the business may not be possible or practically viable. In such a scenario, using a non-fund credit limit to fulfil the guarantee will ensure cash flow issues do not affect his firm's ability to win big contracts.

Advantages of Working Capital Loans

Unlike salaried employees, business persons may not always receive all pending dues in the first week of the month. Receipts may get delayed if customers seek more time. A working capital loan prevents the business from being dependent on a collection of receivables to meet its operating expenses. The business will continue to function properly as long as pending dues are collected at least once a year.

Secondly, these loans can help firms manage unexpected obligations. A demand notice from the tax department would make it necessary for you to pay tax, once an appeal has been filed.Filing a case may result in legal expenses, and government agencies may take time to clear payments despite completion of the contract. Such delays and complications are an inevitable part of business. Working capital loans can ensure the business is equipped to deal with these issues effectively.

Thirdly, these loans ensure the entrepreneur need not reduce his/ her stake by bringing in a financial partner. The loan is granted on the basis of collateral securities and the firm's credibility. Firms pay interest on these loans and limits just like any other debt without any changes to the owner's stake.

Related: This is why calculating Business Loan EMI should be your first step

Finally, working capital loans help a business function more efficiently. Collection of dues from customers will be done on time since any delay will result in additional interest payments on the working capital loan. Unproductive employees will be asked to leave because their salaries are being paid from borrowed money. Even cost-benefit analysis becomes much easier when expenses are being met from such loans and limits.

Shutting a Rs. 25 lakh business due to a Rs. 2.25 lakh shortfall makes no sense. A short-term funding solution is enough to resolve the problem and working capital loans are one of the simplest and most effective tools to safeguard a firm's growth prospects and credibility.