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What is a Working Capital Loan? – Types, Benefits, Eligibility

calendar07 Jun, 2023
timeReading Time: 6 Minutes
What is a Working Capital Loan? - Types, Benefits, Eligibility

A Working Capital Loan is a kind of short-term loan that is used to cover expenditures related to working capital, such as wages and other operational costs. A new injection of cash is required in order to keep a firm running if it does not maintain steady revenues or profitability throughout the year. This kind of funding is typically required by companies that experience cyclical sales or business cycles, whilst other enterprises could need it at times of celebration or when business is very slow. It is possible for such loans to be secured or unsecured, depending on the size of the loan and the financial viability of the company. This suggests that you could be needed to offer collateral in order to secure the loan, but it also might not be necessary. A company’s liquidity and financial health are reflected in its working capital.

A Working Capital Loan is a form of company loan that is meant to satisfy short-term financial commitments and operational needs. It is not intended to support the growth of an existing firm or the acquisition of assets for that business. It’s possible that monthly administrative costs, day-to-day expenditures, the acquisition of fundamental materials, and inventory management all fall under the category of short-term responsibilities. These are some of the most fundamental necessities for running a successful company in the modern day. You will be able to stop worrying about the short-term thanks to the support of a Working Capital Loan, allowing you to instead concentrate on the long-term.

Working Capital Loan durations generally range from six months to four years, with the majority of borrowers being SMEs. However, the length of time varies depending on the banking organisation. Individual financial institutions are also responsible for establishing the interest rates that apply to Working Capital Loans. Your company’s income will be one of the factors that will be used to determine the specific amount of the loan that different banks in India will provide you in compliance with the laws set down by the Reserve Bank of India (RBI)[1].

Characteristics of a Working Capital Loan

After we have established the meaning of the term “Working Capital Loan,” we can go on to looking at the features of these loans.

  • The borrower’s credit history, the track record of the firm, and the length of time the company has been in existence all play a role in determining the amount of a Working Capital Loan. It varies and is adapted to meet the specific requirements of each company’s cash flow situation.
  • Working Capital Loan Calculating the Interest Rate: The interest rate that is attached to a Working Capital Loan varies from one financial institution to the next and is adapted to meet the individual requirements of the borrower.
  • Working Capital Loans may be secured or unsecured, which means that the borrower may or may not be required to provide collateral in order to acquire the loan. A variety of assets, including real estate, stocks, bonds, gold, investments, and even the business itself, may serve as collateral for a loan. The security level of the borrower’s collateral is taken into consideration when the bank determines the terms of the Working Capital Loan. When you apply for an unsecured Working Capital Loan, on the other hand, the lender will investigate your personal financial details, including your credit score and tax records.
  • The repayment period of the loan is flexible so that it may accommodate variations in the cash flow of the firm.
  • Another essential need for obtaining a loan is reaching a certain age threshold beforehand. The borrower’s age must fall within the acceptable range for loans, which is generally considered to be between 21 and 65 years old.
  • When submitting your application for a Working Capital Loan, the lending institution will often charge an application processing fee. This cost is not standard across all financial institutions. It varies from one to the next.
  • Working Capital Loans are offered to entrepreneurs, corporations (public or private), partnerships, sole proprietorships, micro, small, and medium enterprises (MSMEs), as well as professionals and self-employed people without advanced degrees.

The majority of financial institutions provide Working Capital Loans, of which there are a plethora of different types. The following elements make up its entirety:

  • Advance Cash credit facility or overdraft facility
  • Credit for Service Packing
  • Letter of Credit
  • Loans for account recievables
  • Bank guarantee
  • Loan Contingent upon the Provision of a Bank Guarantee against Future Earnings Finance.

Benefits and Drawbacks of Following Working Capital Loan

The most obvious advantage of a loan for working capital is that it helps company owners to quickly and cheaply fill any shortages in working capital expenditures. This is a benefit that cannot be overstated. Even if they are in need of emergency cash, the owner of the business may keep full control of the firm since it is a kind of debt financing that does not entail an exchange of stock. This makes it possible for the proprietor to get money in a pinch.

There are loans for working capital that may be obtained even if you have poor credit. If this is the case, the company that is granted the loan will not be expected to present any kind of security. However, only businesses or the owners of such businesses who have an excellent credit history are eligible for unsecured loans. It is common practise to compel businesses with poor credit ratings to securitize the loans they take out.

One potential drawback associated with obtaining a secured loan for working capital is the obligation to provide collateral. On the other hand, taking out a loan for working capital comes with a number of risks that might potentially arise. Lending institutions are compensated for the risk they take on by being offered interest rates that are rather high. In addition, since loans for working capital are typically secured by the personal credit of the owner, any defaults or missing payments might have a severe impact on the owner’s personal credit.

Eligibility for Obtaining Working Capital Loan

When determining eligibility for a short-term business loan, it is also possible to employ restrictions that are particular to the lender. However, in order to submit an application for a loan for working capital, you will need to first ensure that you fulfil the basic conditions that are mentioned below.

Applicants must be at least 25 years old; businesses must have been operating for at least 3 years; applicants must provide information from their most recent income tax returns; businesses cannot be blacklisted; and their locations cannot be on negative location lists. Trusts, small businesses, and non-governmental organisations (NGOs) are ineligible. Applicants must provide information from their most recent income tax returns.

There is a possibility that extra paperwork concerning your organisation may be required.

Documentation Required for the Working Capital Loan

As was indicated before, the paperwork requirements for a working capital loan are rather low. The following is a list of the papers that you should always have on hand; consult it to decide which ones to keep.

  • Photographs in a format suitable for passports (passport size)
  • Documentation pertaining to the KYC initiative
  • Important Financial Records
  • Documentation attesting to the existence of your company; Current financial statements
  • Bank statements from the previous one fiscal year

Different Kinds of Available Working Capital Loans

There is a secured as well as an unsecured model available. Businesses that are interested in obtaining loans must present collateral in the form of an asset in order to be eligible for secured loans. To acquire an unsecured loan for your company, you will need to demonstrate that your company is financially stable. However, secured loans do not need collateral. The most prevalent forms of working capital loans for small and medium-sized businesses (SMEs) are listed below.

  1. Bank Overdraft / Credit Line: This is the maximum number of cash withdrawals from your checking account that may be authorised in advance by a bank or other financial institution. In order to qualify for a loan, you will need a strong credit score, an appropriate loan amount, and a lengthy history of working together. Even though the maximum amount that may be withdrawn is higher, interest is only computed and paid out on the amount that was actually taken out of the account. The interest rates are normally 1% to 2% higher than the prime rate offered by the financial institution that is providing the loan.
  2. Stock Investments: In addition to the assistance of outside investors, working capital loans secured by equity may also be acquired with the assistance of friends, family, or other close colleagues. New enterprises, as well as existing firms with poor credit scores, are the most popular borrowers of working capital loans.
  3. Short-term Loans: These are among the most common types of finance for working capital that are made accessible to SMEs in India. Loans for working capital with a set interest rate and payback duration of up to a year are available. These loans are backed by collateral, and there may be extra policy requirements attached to them as well, such as a certain level of quotas for sales or revenue.
  4. If you can rely on your customers to pay their bills on time, a Credit-Based Loan against Accounts Receivable Debt based on the value of confirmed sales orders might be a suitable alternative for your company. Additionally, financial institutions are unwilling to issue working capital loans to new businesses.
  5. Obtaining Advances and Using Factoring: This sort of loan is similar to a loan secured by accounts receivable in that it is backed by expected credit card payments rather than by actual sales. However, this sort of debt is appropriate mainly for companies that primarily handle transactions using credit cards.
  6. Commercial Creditor: A trade creditor working capital loan might come from either a new or a current vendor as the lender. When purchasing in large quantities, you will often only have access to this option. On the other hand, commercial creditors will typically set rigorous policy constraints on the borrower.

Conclusion

In conclusion, a loan for working capital offers funding for urgent costs as well as expenses that are on-going. Businesses have the option of making use of these loans in order to improve their overall cash flow. When a firm does not have enough cash on hand or liquid assets to fulfil its immediate operational requirements, it will employ working capital loans to cover those needs. Companies are able to finance their day-to-day operations via the use of borrowings against their core corporate debt.

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