Working capital is the measure of a company’s liquidity required to manage regular operations. All businesses, irrespective of their size or structure, require working capital, given that most of their transactions are usually done on credit. The credit period can be extended anywhere from a few days or weeks to several months. As a result, businesses might not have sufficient liquidity to mitigate short-term obligations. This is where working capital loans would come handy in meeting cash flow mismatches.
Let’s take a look at 5 common working capital loan options available to businesses:
Cash credit is available in lieu of pledge of stock-in-trade, raw materials, work-in-progress, finished goods or against receivables from debtors, shares, fixed deposits, properties etc. A separate cash credit account needs to be opened for availing this facility. While cash credit account holders are permitted to withdraw more than the balance amount maintained in their account, withdrawals made over and above the account balance are allowed only up to a pre-specified limit. Interest is charged on the used limits and not on the limit sanctioned.
Overdraft facility is available to current account holders for cash withdrawals of amount more than what is available in their account. This option is generally offered to those who maintain sizable deposits and have a long-term relationship with their banks. Overdraft limits are determined as per the collaterals provided and interest is levied on the drawn amount, till repayment.
Bill discounting is a fund-based working capital option wherein the bank buys the invoice or bill drawn by the seller and pays the borrower instantly after deducting a certain amount from the submitted bill amount as commission or discount. The bank presents this bill to the purchaser either on or after their due date and directly collects the bill amount from him. In case of any delay in the payment, banks charge a pre-determined interest penalty from the supplier.
In working capital finance, bill discounting is considered as a crucial financing tool that allows businesses to bridge the gap in fund realisation between the sale date and the due date of receiving the payment. This helps in freeing up cash for working capital and other business requirements. Wholesalers, manufacturing firms, distributors and businesses engaged in construction, engineering, transport and logistics are some of the biggest users of bill discounting facilities.
A bank guarantee is an undertaking from the bank assuring the vendor that if the purchaser is unable to settle his debt, the bank will step forward and repay the vendor on the purchaser’s behalf.
For instance, suppose a lesser known ‘Company X’ wants to make the large purchase from a highly established ‘Company Y’. If Company Y is not sure about the capacity of Company X to repay the dues, it would ask the Company X to put forward a bank guarantee. Company X will approach its lender for the bank guarantee, which is issued in lieu of the collaterals and commission. If the Company X is unable to repay Company Y by the due date, the latter can inform the former’s lender and then avail the amount stated in the bank guarantee. Thus, bank guarantees enable businesses to make purchases or enter into other contracts, which they otherwise could not have availed.
Letter of Credit
Letter of credit is a non-fund based working capital facility used for indemnifying the sellers from credit risk. This loan option is mostly used for international trade where the supplier may not be known to importer and the jurisdiction-linked differences increases the credit risk for the supplier. Similar to bank guarantees, banker of the importer issues a letter of credit in the favor of the exporter. The letter of credit issued reassures the exporter to exporting the goods/products to the importer. Once the goods/products are supplied, the exporter presents the letter of credit to the issuing bank to collect the payment.
(By Ajay Mishra, Head-Business Loans @ Paisabazaar.com)