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.
What is Working Capital Loan?
The working capital loan 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 receivable, accounts payable, 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 working capital loans –
- The company may have heavily invested in its capital expenditures hence the shortage of funds for day to day operations.
- Unable to convert its debtors or investments or unable to make sales as it 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.
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- Cash Credit – Cash Credit is a type of bank lending. It provides funds against a pledging or hypothecation 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 facility 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 overdraft is higher than that of loans.
How to Determine the Amount of Working Capital Required?
Use the following formula to determine the amount required for working capital.
- Current Assets are those assets that can be converted within a period of 12 months and Current Liabilities are those liabilities which 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 Liabilities 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.
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 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 = 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 expenditures, 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 goodwill 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 a working capital loan 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 –