Working capital refers to a company’s liquid assets – cash, accounts receivable, inventory, and other assets that can be quickly converted to cash. Most companies use a mix of equity, debt financing, and internally generated cash flows to fund their working capital needs.
However, sometimes a company’s working capital needs might unexpectedly shoot up – due to seasonality, expanding to new markets or other strategic moves. Raising large quantum of working capital at short notice can be challenging.
What is Working Capital Financing?
Working capital financing refers to different types of loans that companies can avail of to fund short-term and cyclical working capital needs. The tenor of working capital loans is usually less than 12 months.
Working capital financing helps plug a company’s liquidity gaps due to:
- Inventories and receivables absorbing cash
- Seasonal or periodic spikes in working capital needs
- Unforeseen events disrupting operations
- Strategic moves requiring additional working capital
Banks and private lenders provide working capital financing through several types of loans like cash credit, overdraft facility, bill discounting, etc. Fintech lenders are also playing an active role here through invoice financing, and inventory financing solutions.
Why Do Businesses Need Working Capital Financing?
Some reasons why businesses might need working capital financing:
To Smooth Cash Flows
Most businesses have seasonal or periodic fluctuations in revenues and expenses. Working capital financing helps tide over low cash months by borrowing money that can be repaid when business picks up. For example, agriculture input companies have high working capital needs before cropping seasons. They are able to repay loans comfortably after farmers purchase inputs on credit.
To Fund Growth Plans
Ambitious growth plans often require significant upfront working capital – to invest in inventory, talent, marketing etc. New age fintechs are classic examples, where working capital ensures growth plans are not stymied due to lack of cash.
Buffer for Unexpected Events
Black swan events like COVID-19 or geopolitical conflicts severely disrupt supply chains and operations. Working capital financing provides a buffer to absorb the financial shocks of such events.
Launch New Products/Enter New Markets
Expansion plans like new product launches, entering new geographies requires investing in new inventory, marketing, distribution channels etc. Working capital financing helps fund these growth initiatives.
Working Capital Financing Options
Some working capital financing options available to businesses are:
Bank Cash Credit
A cash credit facility is like an overdraft account. Companies can withdraw the amount needed from the sanctioned limit to meet working capital needs. Interest is paid only on the utilized amount. The tenor is 12 months, renewable annually.
Bank Overdraft Facility
Similar to cash credit except there is no sanctioned limit. Companies can overdraw from their current account up to a pre-approved overdraft limit. Interest is paid on the overdrawn balance only.
Bill Discounting
Banks can discount or purchase a company’s account payables or receivables and make early payment after deducting interest and fees. This unlocks working capital locked up in outstanding dues.
Letter of Credit
Banks issue a Letter of Credit on behalf of companies to assure their suppliers of payment upon fulfilling the purchase order terms. Suppliers can claim payments from the bank directly upon presenting stipulated documents.
Export Financing
Banks provide working capital loans specifically to fund export operations – like purchasing or manufacturing goods before receiving payments from importers.
Inventory Financing
Specialized loans to fund a company’s inventory purchases from suppliers. Financing is available against all stages of the inventory cycle – raw materials, work-in-progress, and finished goods.
Invoice Trading
Fintech firms purchase a company’s account receivables at a discount. This immediately unlocks working capital stuck in unpaid customer invoices.
Working Capital Financing Costs
Key costs involved in working capital financing are:
Interest Rates
Interest rate is usually tied to 1-year MCLR or Base Rate of bank/NBFC providing the loan. A spread is added over this base rate – between 2% to 10% depending upon credit rating and risk perception of the borrower. Overall interest rate typically ranges from 10% to 22% p.a.
Processing Fees
Lenders charge a one-time upfront processing fee – usually between 0.5% to 2% of the loan amount sanctioned. This compensates lenders for expenses incurred on documentation, diligence, vetting etc.
Foreclosure Charges
Borrowers have to pay prepayment or foreclosure charges if they repay the working capital loan before completion of the 12-month tenor – usually 2% to 5% of amount foreclosed.
Collateral Security
Banks and NBFCs nearly always securing working capital loans against a collateral like property, fixed deposits or business assets to mitigate default risks. SMEs are often unable to provide adequate collateral leading to lower credit availability.
Renewal Fees
Lenders charge renewal fees on rollover of facilities upon expiry of 12-month tenor. This involves fees on enhanced limits if any, documentation, updated financial statements etc. Renewal fees are usually between 0.25% to 1% of renewal amount.
Other Charges
Agreements also often include other provisions like – non-utilization charges if company under-utilizes sanctioned limits, penal interest on delays, prepayment penalties etc. to protect lender interests.
Careful assessment of these costs involved is important to determine the viability of different working capital financing options. The option with least overall cost and easiest availability should be preferred.
Industry Terms and Practices
Working capital financing terms and practices may vary depending upon factors like:
Type of Company
Lenders prefer extending working capital loans to companies with proven cash flow models rather than early-stage ventures. Established companies get better terms.
Company Size
SMEs and mid-sized companies often lack collateral security leading to higher interest rates and stringent credit limits for them. Large corporates get cheaper, hassle-free financing.
Industry Characteristics
Industries like manufacturing with regular cash flows get working capital easily unlike cyclical sectors like real estate or agriculture.
Lender Type
NBFC rates are higher than banks due to higher risk tolerance and operating costs. New fintech lenders focus more on business viability than financial statements while approving loans.
Payment Capabilities
Companies with robust payment records and ratings get better pricing and limits compared to others with patchy track records.
Seasonality
Companies with major seasonal or periodic fluctuations in working capital rely more on short tenor financing that can be easily pre-closed.
Collateral Banks insist on 200%+ collateral coverage for working capital loans to SMEs. Higher value collateral like property or liquid assets results in lower interest rates.
Therefore a profitable, reputed mid-sized manufacturing company will get cheaper working capital financing than a fledgling start-up or smaller business in the hospitality sector.
Conclusion
Working capital is the financial lifeline for companies to operate smoothly and fund growth. Working capital financing through loans and advances plugs temporary liquidity shortages that may arise from various business compulsions.
Banks, NBFCs and fintech lenders offer a range of working capital financing solutions to suit every business need.