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 is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. , 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., 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
Why Companies Require Working Capital Loan?
There can be many reasons why companies may opt for such loans –
- The company may have heavily invested in its capexCapexCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year. hence the shortage of funds for day to day operations.
- Unable to convert its debtorsDebtorsA debtor is a borrower who is liable to pay a certain sum to a credit supplier such as a bank, credit card company or goods supplier. The borrower could be an individual like a home loan seeker or a corporate body borrowing funds for business expansion. or investments or unable to make sales as expected.
- Unexpected cash requirement.
- Shortage of funds to take up new projects/sales orders or purchase raw material at a lower market rate.
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.
- Cash Credit – Cash Credit is a type of bank lending. It provides funds against a pledging or hypothecationHypothecationHypothecation is a process where a lender receives an asset offered to him/her as collateral security. It is done mainly in assets that are movable in nature to establish the charge against collateral security for a particular loan. of goods. Under this arrangement, the bank determines the limit as per customers’ requirement and up to which the customer can draw funds as and when required. The interest is calculated accordingly and charged in the account. In the event of failure of repayment, the money is recovered from the goods which are pledged/hypothecated.
- Overdraft – Overdraft is very similar to a cash credit facilityCredit FacilityCredit Facility is a pre-approved bank loan facility to businesses allowing them to borrow the capital amount as & when needed for their long-term/short-term requirements without having to re-apply for a loan each time. , except there is no pledge/hypothecation of goods. Here the bank allows the customer to withdraw funds over and above the credit limit of the customer. This facility is granted on written request from the customer. The interest rate on overdraftOverdraftOverdraft is a banking facility that offers short-term credit to the account holders by allowing them to withdraw money from their savings or current account even if their account balance is or below zero. Its authorized limit differs from customer to customer. is higher than that of loans.
How to Determine the Amount of Working Capital Required?
- Current AssetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc. are those assets that can be converted within a period of 12 months, and Current Liabilities are those liabilities that are due within 12 months.
- Current Assets include stock of raw materials, work-in-progress, finished goods, cash/bank balance, accounts receivable and investments which can be converted into cash within 12 months.
- Current LiabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc. include accounts payable, outstanding expenses, taxes, which are due within 12 months.
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 = Inventories (Raw material + work in progress + Finished Goods) + Current Investments + Prepaid ExpensesPrepaid ExpensesPrepaid expenses are expenses for which the company paid in advance in an accounting period but which were not used in the same accounting period and have yet to be recorded in the company's books of accounts. + Short term loans and advances + Trade receivables + cash and cash equivalents Cash And Cash EquivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation. Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. + Advance Tax
- = $ (1,000 + 800 + 1,200 + 4,000 + 2,000 + 4,500 + 1,500 + 10,000 + 9,000)
- = $ 34,000
- 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 –
- Working Capital = Current assets – Current liabilities
- =$34,000 – $ 25,000
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.
- It helps business or entrepreneurs to focus their attention on capital outlays, project financing, expansions, new products, and ideas.
- Depending upon the creditworthiness, a loan can be easily obtained from the bank at a low-interest rate.
- It helps the businesses to settle their creditors and other expenses, which in turn maintains the goodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company's net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company's net identifiable assets from the total purchase price. of the firm and also causes smooth functioning of day to day operations.
- 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.
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 –