Mr. Anil owns a small manufacturing company. While aggressively promoting his new business, he landed a very lucrative deal, a huge order from a famous MNC to supply his goods which obviously he couldn’t resist. The MNC promised a fraction as advance payment, but the balance was to be paid on completion of the entire order. His biggest challenge was overcoming the immediate cash crunch, to bridge the current outflow and the future inflow of cash. What did Mr. Anil do?
This situation is a typical example of where working capital financing comes in handy. When a company's working capital is insufficient to meet its obligations, it must obtain financing.
But before we discuss working capital financing, let’s understand working capital. Working capital represents the amount of cash available to a business to meet its current needs. In technical terms, it represents the amount by which the current assets exceed the current liabilities. Generally, current assets are those which a company's management believes will convert to cash within a year, while current liabilities are the company's debts and other obligations that are payable within one year.
A loan is a borrowing made by a person with an expectation that the same will be repaid in the future, often with an additional amount called interest. 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 but are used to provide the working capital to cover the company's short-term operational needs. Those needs can include costs such as payroll, rent, stock purchases and other miscellaneous expenses.
An important consideration for every company is how to source such funds. An entity may obtain a working capital loan due to reasons such as a large order, inadequate cash (liquid, available cash) or non-linear revenue patterns. There are a number of loans available in the market, from which Anil may choose one that best suits his requirement -
1. Term Loan: One can approach his banker or a financial institution with a proposal for a one-year term loan. A company having an existing relationship with a bank may make an informal proposal with just a meeting with the bankers and providing current financial information. If the applying company isn't well known by the bank or the financial institution, its owner or chief financial officer can consider providing a business plan along with current financial information and a summary of its projected operating cycle during the coming year.
2. Revolving Credit: Revolving credits function like credit cards. In Anil’s case, he can borrow money to supplement working capital when needed and repay the advances when collections accumulate to a sufficient level. Banks normally charge fees on revolving credits. The main advantage of a revolving credit from the borrower's point of view is that it is governed by a contract with the bank.
3. Factoring: In factoring, a company will obtain money for working capital by selling accounts receivable to a lender, called a factor, for a discounted amount. Typically, the factor advances 80 percent of the number of invoices, creating a 20 percent reserve, less a discount fee, which can be up to 3 percent. When the factor collects the invoice payments, it returns the reserve to the company.
4. Trade Creditor: A very simple form of working capital loan is from the company’s own trade creditors. When a present or potential supplier is willing to postpone his payments, the company has postponed its present outflow to a future date and hence has more cash for immediate use.
5. Bank Overdraft Facility: One may choose to obtain a simple overdraft facility from his existing banker. The company’s relationship with the bank decides the interest rate and the maximum line of credit that it can receive. One great benefit of the bank overdraft facility is that the interest is applicable only on the overdrawn amount and only for the periods overdrawn.
6. Exporters' Working Capital Guarantees: The Export-Import Bank of the United States is a federal agency that promotes exporting by enabling U.S. companies to compete effectively with foreign suppliers. One of its programs, which it designed specifically for smaller businesses, is the Working Capital Guarantee program. Lenders, usually commercial banks, who participate in this program receive guarantees of their loans to exporters to the extent of 90 percent of principal. The program enables smaller companies to expand into international markets without encroaching on existing credit limits at their banks. Loan proceeds must be used to fulfill orders from foreign customers.
With these options available, Anil is a very happy man. He can now confidently accept the lucrative order, as he is longer worried about the immediate lack of own funds. What allowed him this confidence is that he recognized and funded the gap in his cash flows. What previously looked like a financially impossible proposal is today his biggest source of revenue!
Stay tuned to find out more on common business conditions where such loans make running your business easier and why you should seek working capital loans.