Friday, June 10 2022

All businesses, regardless of size or structure, need working capital, since most of their transactions are usually done on credit.

Working capital is the measure of a company’s cash needed to run regular operations. All businesses, regardless of size or structure, need working capital, since most of their transactions are usually done on credit. The credit period can be extended from a few days or weeks to several months. Therefore, companies may not have sufficient cash to mitigate their short-term obligations. This is where working capital loans would come in handy to deal with cash flow mismatches.

Let’s take a look at 5 common working capital loan options available to businesses:

Cash credit

Cash credit is available in lieu of pledging inventory, raw materials, work in progress, finished goods or against claims on accounts receivable, shares, fixed deposits, property, etc. A separate cash credit account must be opened to avail of this facility. While cash credit account holders are allowed to withdraw more than the balance amount maintained in their account, withdrawals made in excess of the account balance are only permitted up to a predefined limit. Interest is charged on the used limits and not on the sanctioned limit.

Overdraft facility

The overdraft facility is available to current account holders for cash withdrawals in excess of what is available in their account. This option is generally available to those who maintain large deposits and have a long-term relationship with their bank. Overdraft limits are determined on the basis of the guarantees provided and interest is charged on the amount withdrawn, until reimbursed.

Invoice discounting

Bill discounting is a funds-based working capital option in which the bank buys the bill or bill drawn from the seller and pays the borrower instantly after deducting a certain amount from the amount of the bill submitted as commission or discount. The bank presents this invoice to the buyer on or after the due date and collects the invoice amount directly from him. In case of late payment, banks charge a predetermined interest penalty to the supplier.

In working capital financing, invoice discounting is considered a crucial financing tool that allows companies to bridge the cash realization gap between the date of sale and the due date of receipt of payment. This helps free up cash for working capital and other business needs. Wholesalers, manufacturing companies, distributors and companies engaged in construction, engineering, transportation and logistics are some of the biggest users of bill discounting facilities.

bank guarantee

A bank guarantee is a commitment by the bank assuring the seller that if the buyer is unable to settle its debt, the bank will intervene and reimburse the seller on behalf of the buyer.

For example, suppose a lesser-known ‘Company X’ wants to make a major purchase from a well-established ‘Company Y’. If company Y is not sure of company X’s ability to repay the contribution, it will ask company X to present a bank guarantee. Company X will approach its lender for the bank guarantee, which is issued in lieu of collateral and commission. If company X is unable to repay company Y on the due date, the latter may inform the lender of the first and then avail itself of the amount mentioned in the bank guarantee. Thus, bank guarantees allow companies to make purchases or enter into other contracts, which they would otherwise not have been able to benefit from.

Letter of credit

Letter of credit is a non-fund based working capital facility used to indemnify sellers against credit risk. This lending option is primarily used for international trade where the supplier may not be known to the importer and jurisdictional differences increase the credit risk for the supplier. Similar to bank guarantees, the importer’s banker issues a letter of credit in favor of the exporter. The letter of credit issued reassures the exporter that the goods/products will be exported to the importer. Once the goods/products have been delivered, the exporter presents the letter of credit to the issuing bank to collect payment.

(By Ajay Mishra, Head of Business Loans @ Paisabazaar.com)

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