Working Capital Loan

What is Working Capital Loan?

Working Capital Loan is a loan taken by a company to finance its day to day operations like funds to cover the operational needs of the company for short duration like for any debt payments, rents or payroll and it is not meant to meet the needs for long term investments or assets.

In simple words, it is a short term loan taken by the company to meet its day to day requirements of the business. Working capital is a short term capital requirement by every business to meet its day to day operational cost. It includes short term cash requirements to purchase raw materials or finished goods, payment for expenses, accounts receivableAccounts ReceivableAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet.read more, accounts payableAccounts PayableAccounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period.read more, etc. The liquidity of a company can be measured by its working capital, which tells us its capacity to meet short term cash requirements/obligations.

Working Capital Cycle

working-Capital-cycle

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For eg:
Source: Working Capital Loan (wallstreetmojo.com)

Why Companies Require Working Capital Loan?

There can be many reasons why companies may opt for such loans –

Types of Working Capital Loan

Most common types of working capital loans, where the amount of loan is not very significant and usually for small businesses.

How to Determine the Amount of Working Capital Required?

Working Capital = Current assets – Current liabilities

Example

Let’s understand this working capital with an example. The following details are available from the Balance Sheet of XYZ Ltd.

  • Inventories-Raw Material: $1,000
  • Inventories-Work in progress: $800
  • Inventories-Finished Goods: $1,200
  • Current Investments: $4,000
  • Short-term Borrowings: $15,000
  • Prepaid Expenses: $2,000
  • Short Term Loan and Advances: $4,500
  • Trade Receivables: $1,500
  • Trade Paybles: $2,500
  • Short Term provisions: $2,500
  • Other Current Liabilities: $5,000
  • Fixed Assets: $80,000
  • Cash and equivalents: $10,000
  • Advance Tax: $9,000

For the calculation of working capital, we will first calculate current assets and current liabilities –

Current Assets

working capital loan example 1.2
  • Current Assets = Inventories (Raw material + work in progress + Finished Goods) + Current Investments + Prepaid Expenses + Short term loans and advances + Trade receivables + cash and cash equivalents + Advance Tax
  • = $ (1,000 + 800 + 1,200 + 4,000 + 2,000 + 4,500 + 1,500 + 10,000 + 9,000)
  • = $ 34,000

Current Liabilities

example 1.3
  • Current Liabilities = Short term borrowings + Trade payables + Short term provisions + Other current liabilities
  • = $ (15,000 + 2,500 + 2,500 + 5,000)
  • = $ 25,000

Therefore Working Capital will be –

example 1.4
  • Working Capital = Current assets – Current liabilities
  • =$34,000 – $ 25,000
  • =$9,000

A lot of judgments and estimates should be taken into consideration while calculating the working capital loan. This will help not only to loan adequate amount covering all expenses but will also reduce the interest on a loan that needs to be paid to the bank. Large businesses will usually have in-house resources which can determine the working capital loan amount. In other cases, entrepreneurs can seek outside professional help from firms who help businesses to meet their financial needs.

Advantages

Disadvantages

  • The frequent requirement of working capital loans can be interpreted as management’s inefficiency to manage its short term cash requirements.
  • It also shows management’s lack of attention to its working capital requirements and more focus on capital expenditure/expansion.
  • Loss of goodwill due to its inability to pay its creditors on time;
  • Frequently requesting for such loans can have a negative impact, and banks may not sanction such loan.

Recommended Articles

This has been a guide to Working Capital Loan and its meaning. Here we discuss the common types of working capital loans, its advantages, and disadvantages and how to determine the amount of working capital required for a business with the help of an example. You can learn more about accounting from the following articles –

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