Every business, small or large, needs money to cover its daily expenses. For MSMEs and startups that are yet to realize huge revenues, it might be a challenge to maintain a positive cash flow. In such cases, businesses turn to financial institutions to borrow capital. One such type of loan that is widely available in India is the working capital loan. Read along to understand how working capital loans work and how you can secure it for your startup or small business.
If you are looking to learn more about other types of business financing, here are some of our recent blog posts:
- How to get a startup loan without collateral – A Comprehensive Guide
- How to Get eCommerce Business Loans in India?
- A Comprehensive Guide on Startup Business Loan in India 2022
- What Are Unsecured Business Loans: Guide For Startups And Small Businesses
What Is A Working Capital Loan, And When Do You Need It?
If you’ve followed our blog, you would have noticed us mentioning working capital loans in a few other blog posts. A working capital loan is a type of business loan availed by startups and MSMEs to cover their day-to-day business needs and maintain liquidity when they are short of capital. A type of short-term loan, this loan is primarily availed by businesses when their current liabilities outweigh their current assets. The usual tenure of the loan is 6-12 months. The eligibility criteria for availing of a working capital loan varies from lender to lender.
The interest rates for a working capital loan can range from 11-16%. A company is said to have a positive working capital if it has enough cash, accounts receivable, and other liquid assets to cover its short-term obligations.
If a business has enough working capital, it can continue to pay its employees and suppliers, and meet other needs, such as loan interests and taxes, even if it runs into cash flow challenges. If the business does need to take another loan, showing a positive working capital can make it easier to qualify for loans and other forms of credit. A business can also avail of the working capital loan if it is seasonal in nature and has a good credit score. Seasonal businesses tend to have sales only during a particular season, which means that the business does not have a steady cash flow throughout the year. In such cases, working capital loans can come in handy. A working capital loan isn’t ideal if you have inconsistent revenue and are unsure if you will be able to make monthly payments.
Advantages And Disadvantages Of Working Capital Loans
Working capital loans have their own distinct advantages and disadvantages. Some of them are:
- You will have the cash on hand to deal with any cash flow problems
- The business owner need not share the ownership of your business (no equity dilution)
- Working capital loans can be secured or unsecured, and in the case of the latter, you don’t have to plead any collateral
- The repayment tenure is short and flexible for the applicant
- You can spend the money however you want
- The eligibility criteria is simple, and the documentation is easy
- You have to repay the capital with interest as monthly payments
- In the case of secured loans, you will need to pledge collateral
- You may be charged a high level of interest
- Your credit score/credit history will be compromised in case of default
- You may have to repay quickly
Working Capital Loan Calculation: How Much Loan Would You Need
One formula you need to keep in mind while estimating the working capital you would need to ensure a positive cash flow and for your daily operations is:
Working Capital = Current Assets – Current Liabilities
Current assets include cash, accounts receivable, and inventory. Current liabilities include accounts payable, taxes, wages, and interest owed.
For example, let us assume your current assets stand at INR 50,000, and your liabilities stand at INR 23,000. Your working capital, in this case, would be the former minus the latter, i.e., INR 27,000.
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 ensure day-to-day operations.
5 Types of Working Capital Loan For Your Startup
In our previous blog posts, we have covered the different types of loans available for startups, women entrepreneurs, etc. Working capital loans are easily available in the market today for business growth, and you can find multiple lenders in addition to traditional banks who are willing to provide working capital loans. There are many ways in which you can avail a working capital loan. Here are the top 5 most commonly availed working capital loans today:
- Bank overdraft facility: One of the most commonly used types of working capital loan, an overdraft facility is where a bank or any other lender sanctions a cash loan per the business’ needs by setting up a bank account. The business owner may borrow any amount of cash from this account up to a maximum limit fixed by the lender. For such loans, the interest is applicable only on the borrowed amount and not the maximum limit.
- Letter of credit or business line of credit: A letter of credit is a letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. If the buyer cannot make a payment on the purchase as agreed, the bank will be required to cover the full or remaining purchase amount.
- Invoice financing: Invoice financing is a type of short-term borrowing that is provided by the bank or a lender to its customers based on unpaid invoices. A business may use invoice financing to improve cash flow for operational needs or speed up expansion and investment plans. Businesses pay a percentage of the invoice amount to the lender as a fee for borrowing the money.
- Bank guarantee: A non-fund-based working capital financing, a bank guarantee is acquired by a seller to reduce the risk of loss to the opposite party due to non-performance of the agreed task. The bank might charge some commission for the same and may also ask for security/collateral in exchange.
- Trade credit: A trade credit is an arrangement or understanding that allows businesses to buy goods and/or services on an account without making immediate cash or cheque payments. It is a helpful tool for growing businesses when favorable terms are agreed upon with a business’s supplier.
Working Capital Loan Vs. Long-Term Loan: What Is The Difference?
|Differentiator||Working Capital Loan||Long-term Loan|
|Tenure||A working capital loan is usually taken to deal with immediate cash requirements or short-term needs and can range from 6-12 months||Long-term loans are availed for meeting long-term needs and can have repayment tenures of up to 5 years|
|Purpose||To meet cash crunch and working capital needs||Business expansion plans, purchase of equipment /machinery, or renovation of office premises|
|Interest Rates||High interest rates||Comparatively lower interest rates|
|Loan Amount||Smaller amount to ensure a positive cash flow||Larger amount to meet varied needs|
|Ease of Availability||Easier to avail||Comparatively harder to avail due to more procedures|
Use Revenue Based Financing For Your Working Capital Needs
Working capital loans can be extremely beneficial when you are in a cash crunch. However, availing the same can be tricky business. If you are looking for a flexible, highly scalable, 100% digital process of raising funds that require no equity dilution, we recommend revenue-based financing (RBF).
Revenue-based financing is a way that firms can raise capital by pledging a percentage of future ongoing revenues in exchange for money invested. Revenue-based financing is relatively cheaper than equity financing options available in the market. RBF investors would not take board seats or place difficult financial covenants on your business. Since the repayment is based on the turnover, in case you are having a bad month, you have the flexibility of repaying a smaller amount. It doesn’t end there! Revenue-based financing has a host of benefits for startups that have a decent turnover and are looking to meet their business needs.
We at Velocity, offer founder’s friendly, revenue based financing of upto 4 Cr to Indian D2C and Ecommerce businesses. If you are a D2C brand looking for funding to manage your inventory and marketing needs, apply here, and get funded within 7 days.