The A to Z of Working Capital – Chapter 2
The previous blog spoke of how to recognize and fulfill workings capital needs. A quick recap –Working capital loans are loans taken to finance a company’s everyday operations. These loans are not used for long-term assets or investments, but are used to provide the working capital to cover the company’s short-term operational needs. The needs may include costs such as payroll, rent, stock purchases and other miscellaneous expenses.
There are certain common business conditions which necessitate a working capital loan, and these are inherent to most businesses. While they are not fundamentally negative, handling them inappropriately may severely hinder the business. Below are some such common conditions –
1. Inadequate cash in hand: The company may not have adequate cash on hand or asset liquidity to cover day-to-day operational expenses, but its operations cannot be put on hold until its receivables are realized. Such a company may secure a loan for this purpose.
2. Unstable revenue patterns: Many companies do not have stable or predictable revenue throughout the year, due to their business being seasonal. For instance, some manufacturers sell most of their products during the festive seasons. But they may produce during off-season to fulfill peak season demand. Such companies often opt for a working capital loan to pay salaries and other daily expenses
3. To produce a huge order: It can be quite frustrating to lose a big opportunity due to insufficient funds (as was the case in our previous case study of Mr. Anil). A working capital loan can help a business owner in grabbing that opportunity by offering the required funds. It can turn out to be good for the business in the long run.
4. Indirectly help in growth: It helps the business to use its retained earnings and other cash inflows for investment in long term projects and thus provides better opportunity for business growth.
Like with all else, a working capital loan must be sought after giving sufficient thought to all its pros and cons –
1. The immediate benefit of a working capital loan is that it is easy to obtain and lets business owners efficiently cover any gaps in working capital expenditures.
2. It is a form of debt financing and does not require an equity transaction, meaning that a business owner maintains full control of their company, even if the financing need is dire.
3. Some working capital loans are unsecured. If this is the case, a company is not required to put down any collateral to secure the loan. However, only companies or business owners with a high credit rating are eligible for an unsecured loan. Businesses with little to no credit must provide security for the loan.
4. Companies can get short-term loans that include inventory loans, accounts receivable credit or bank lines of credit in shorter time. These loans are generally flexible with varying repayment terms and interest rates, that help the firms with seasonal fluctuations, in smoothening out their cash flow.
5. Generally, working capital loans have little to no restrictions. The only thing the lender expects is that the company uses the cash for increasing revenue or maintaining daily operations.
6. Irrespective of the requirement and monthly revenue, working capital financing helps maintain good cash flow for your business. This means that your business gains stability and financial strength for urgent or unexpected needs
1. Interest rates are high to compensate the lending institution for risk., which results in a higher financing cost to the borrower and thereby a lower profit.
2. Working capital loans are often tied to a business owner’s personal credit, and any missed payments or defaults will hurt his or her credit score
3. The company may not be able to avail a working capital loan if it does not have a good credit history.
What the two blog posts on the ‘Basics of Working Capital’ hope to convey are – Choosing the right option for your business is to be decided considering the required timelines, financial situation and the nature of business. More often than not, the best solution is to find the right blend of different options.
Ashwin Ramesh is a Chartered Accountant employed at the World Bank, at Chennai. He studied at Sri Sathya Sai Institute of Higher Learning, Brindavan which has greatly influenced his approach to life and is a firm believer in their teachings. He is also a public speaker, has participated in debates, is a sports enthusiast and has played football and cricket at school, college, office and club levels. He is passionate about Carnatic music and is a singer himself. He also pursues acting as a hobby. His writing is not restricted to his well-informed blogs on finance or economics but also extends to cricket, football and his other interests, which you may access on his social media handles. And it is our privilege to have him as a guest blogger at Capital 9!