Working capital finance is designed to make better the functioning capital accessible to businesses. It is often utilized for definite growth projects like big contracts or new market investments. Most of the businesses make use of working capital for various purposes.
However, the main idea behind the working capital finance is that it frees up the need of cash for the developing business. Also, it will be recovered within a short or medium term.
Working capital finance can be done through different modes like cash credit, trade credit, working capital loan, factoring, bank guarantee, inter-corporate deposits, discount/ purchase of bills, overdrafts, etc.
So, there are different mediums of money lending that can be considered as working capital finance. However, it entirely depends on the specific sector or other requirements.
What is the meaning of Working Capital Finance?
Working capital finance is the amount of money that a business is able to spend safely. It is the capital that is used by a business to finance day to day operations. It is commonly referred to as existing assets minus existing liabilities. It is calculated on the basis of assets, expenses, and cash or invoices.
For instance, if a business holds $5,000 in a bank account, one of their customers owe $4,000, a supplier’s invoice and a bill worth $2,000 and $4,000, respectively then, its working capital finance would be $3,000. It is calculated as: (5000+4000)-(2000+4000)=3000.
Working capital finance is seen to be “working” because a business could utilize it. This liquid cash is required for big contracts, business investments, buying stocks, and other such activities.
So, it is cash that can be accessed quickly but not tied up for a longer term.
Meanwhile, if a business is a profitable one but holds huge bills that need to be paid soon, then working capital of that business can be negative or even worse in no less time.
Who takes care of Working Capital Finance?
Working capital is of great significance in a business. It is a vital activity that requires incessant attention because it helps in keep going of business’s day-to-day activities. It is the duty of a finance manager to take care of the working capital for the smooth functioning of a business.
A business could get in troubles with insufficient or inappropriate working capital financing. Without sufficient working capital, a firm could not be able to pay dues within a specific time-period. However, working capital finance even affects the firm’s profits.
What are the different kinds of Working Capital Finance?
There are various kinds of lending in businesses ranging from small to big ones that can be considered as working capital finance. These different ways of working capital financing depend on the sector to sector.
These types are designed after the requirements of each and every sector. One could choose one type of working capital financing as per needs and requirements. Here, some of the common kinds of working capital finance.
Bank overdrafts or cash credits are the most valuable and common medium of working capital finance for small or big businesses in almost every sector. This facility is offered by various commercial banks to borrowers, where they get sanctioned a certain amount for bringing out their business payments.
A borrower could not cross the endorsed limit. However, the interest is put down on the used amount rather than the sanctioned one, which encourages the borrower to deposit the amount without delay in order to save interest amount. It is definitely effective working capital finance.
2. Working Capital Loans
These loans are for a short and medium term, which is intended to enhance the growth of the business through new opportunities. The amount for the working capital loan depends on various facets of a business.
In order to get a working capital loan, you need to put your assets on security. The amount you borrow will be restricted through assets at hand. You can pay back these loans in a lump sum or installments at the end.
3. Trade Credit
It is the period that is extended by the business’s creditor on the basis of creditworthiness. It is reflected through various factors such as liquidity position, payment records, and earnings.
This working capital financing is designed for businesses that deal with physical stocks. In this case, the delay in payments is rendered by the lender and not by the supplier. It is kind of a complex working capital financing.
4. Discount/Purchase of Bills
This service for working capital finance is also offered by commercial banks. Every business produces bills while selling things to debtors on a normal course. Now, that invoice acts as a legal paper to receive that specific amount from the non-payer.
In case of money requirement, the seller will go to a bank with that invoice. The bank will then pay the amount to that person after applying the discount on the basis of current interest rates. On the maturity date, the bank will collect money from the debtor.
For instance, if you have a VAT tax that is putting so much strain on the working capital of your business then, you can receive funding from that tax bill. You will receive a loan on the basis of that bill, which will be helpful in spreading costs for up to twelve months. So, a tax bill funding will also be helpful for working capital financing.
In small businesses, factoring takes place rather than discounting. Factoring comprises credit controls, which can be used for invoices with lower amounts only.
It is an agreement where a business trades selected or all accounts to another party at lower prices than the actual ones. The other party is the provider of factoring services to small businesses. Factoring is done through two ways i.e. with recourse or without recourse.
6. Bank Guarantee
It is a working capital finance based on non-funding. A seller or buyer needs to acquire a bank guarantee in order to reduce risks to the opposed party due to some loss in business and hence, failed to repay the amount.
It can only be rescinded by the owner of if the opposed party could not perform well. On the other hand, the bank asks assets for safekeeping or charges commission for the same.
7. Merchant Cash Advances
Merchant cash advances are another useful medium to boost working capital finance. It is best for those businesses where payments are accepted through card terminals from customers.
As its name suggests, it makes a cash advance for a merchant. It is useful for businesses such as cafés, pubs, retailers, restaurants, etc. Here, the advanced amount is expressed in a percentage of average monthly revenues.
8. Asset Refinancing
If you are unable to get funding from business loans then, you can use your assets in order to raise capital finance. The amount you need to borrow entirely depends on assets you are using to lock funding against. In an asset refinancing, you are not required to engage your home or any other guarantee.
9. Credit facilities
Alike overdrafts, credit facilities provide you with a pre-approved funding that you can use whenever needed. It does not require a specific account to carry the payment and can be directed anywhere. Here, providers charge interest on funds and on the due date, ask for the amount.
10. Letter of Credit
It is kind of a working capital finance that is done on the basis of non-funding. The difference between a bank guarantee and a letter of credit is not much. In a bank guarantee, it is revoked if the opposed party could not perform well whereas, in a letter of credit, the bank pays the opposed party if it performs according to the agreement.
Thus, a consumer will buy a letter of credit and then, give it to one of his retailers. When the retailer starts to perform according to the agreement then, the bank will start to collect cash from the consumer and pay to the retailer.
So, these are some of the different modes of working capital finance. However, there are other sources as well like public deposits, commercial papers, inter-corporate deposits, etc. It entirely depends on circumstances as well as on business sectors to go with what sort of source.
Working Capital is mainly the difference between a business’s assets and its liabilities. It tells about the company’s efficiency with the help of its balance sheet.
A company’s operating costs run the whole business, which includes taxes, payrolls, administrative costs, sales costs, etc. If a business does not have sufficient working capital to meet its operating costs then, that business is financially vulnerable.
So, a company should take care of the working capital or else, it could have drastic effects on the growth of the business. Working capital finance is a medium to boost the growth of the business.
There are different sources of working capital financing that can be chosen based on the needs and requirements of a business.