Working capital is essential for the smooth functioning of any business. It is the fund required to pay salaries, rent and other expenses that are incurred in the process of doing business. Small business owners need to pay close attention to the management of their working capital, and ensure that it is enough for day-to-day functioning.
There may be times when, in spite of the greatest care and judicious use of resources, the working capital proves insufficient to meet the necessary expenses. In such a situation, the only option available to the business owner is working capital financing. Here we will tell you about the different types of working capital loans that can be availed.
As the name suggests, these loans are for the short term and come with a fixed interest rate as well as payment period. They are secured loans and require collateral. These loans can be repaid in instalments or as lump sum payments.
Also known as cash credit, this loan is considered most appropriate for financing of small businesses. In bank overdrafts, the banks sanction a particular amount that can be utilised for making business payments. The great thing about these loans is that the borrower is only charged interest on the amount taken, and not on the sanctioned amount.
Purchase/Discount Of Bills
Every business generates bills while selling goods/services to debtors. The bill is a document whose purpose is to receive payments from the debtor. In the situation where the seller is in need of money, he can go to the bank along with the bill. The bank will then calculate the payable amount by discounting the total amount, based on the current interest rate. This amount will then be paid to the seller. When the bill reaches maturity date, the bank will approach the debtor and collect money from him.
This is an arrangement in which the business sells a part or all of its account receivables to a third party. The price of this sale is lower than the value that can be realised by these accounts. The third party here is called the ‘factor’ (a factoring service provider to businesses), who provides financing by purchasing the accounts.
The factor also takes responsibility for collection of the pending amount from debtors. There are two types of factoring services – with recourse and without recourse. In with recourse, the risk of non-payment is borne by the business, but in without recourse, the risk is absorbed by the factor.
This type of credit is offered to businesses based on their creditworthiness, which is in turn, is gauged by looking at their payment records, profit records and liquidity situation. The novel aspect of this loan is that it can be given by both, present or potential suppliers of business. Like all other working capital financing options, trade credit also comes with specific costs and requirements. This loan is a relatively costly way of securing finance for your business.
Letter Of Credit
It is also known as a non-fund based form of working capital finance. A letter of credit is an agreement between the buyer and seller, in which the buyer purchases the letter of credit and sends it to the seller. Once the seller delivers the product according to the agreed terms, the bank will pay the seller and then collect the cash from the buyer.