Every business requires funds to meet their day to day expenses. These expenses are recurring and unavoidable. The funds used to meet these expenses is known as working capital. As the name suggests, working capital is the money that helps run the business on a day to day basis. Working capital is the difference between the assets owned by the company and the liabilities owed by the company. Some lenders offer working capital loans for businesses to meet the short term deficit of funds.

In simple words, a working capital loan is taken to finance the operational expenses of a company. In case of shortage of cash flow, a company might have to resort to a loan. The funds received can be used for debt payments, paying suppliers, managing overhead costs and paying employee wages. The loan is not suitable for long term investment or purchase of assets. It has a short tenure and is only designed to help meet the immediate fund requirement of the business.

Modes of disbursal

There are several modes of disbursal of working capital loans, including a letter of guarantee, letter of credit, cash credit, bill discounting, term loan, packing credit and others. Most lenders do not ask for a security or a third party guarantee if the amount borrowed is less than Rs. 1 crore. However, different lenders have varying criteria for the loan.

How do banks review the working capital requirements?

When a bank receives an application for a working capital loan, there are certain calculations that the lender will make before the approval of the loan. Most banks use the working capital calculation formula to estimate the right amount.

The current assets of the company include:
• Cash in hand,
• Stock or inventory
• Debtors
• Prepaid expenses

The current liabilities may comprise:
• Outstanding creditors
• Outstanding expenses
• Short term debts.

The formula for working capital = Current Assets- Current Liabilities

• Any cash commitments like the buyback of shares and declared dividends should be excluded,
• Non-trade receivables like a loan to employees should be deducted from debtors.
• Obsolete inventory should be deducted from the total stock.

Using the information from your balance sheet and income statement, the lender will be able to estimate the deficit and will identify the loan amount. However, other factors play a significant role in the working capital loan. These are discussed below.

1. Nature of the business: The nature of business will speak a lot about the working capital needs. The working capital needs of a seasonal business will be very different. If you have a seasonal business, you will require funds in the peak season. Banks will consider this factor when you apply for a loan.

2. Time consumed for the conversion of raw materials into finished goods: Different businesses have varying conversion time of raw materials into finished goods. This means that the working capital requirement will vary accordingly. If you have a short conversion period, your requirement will be low as compared to a long conversion period where the raw material remains in the process for a long time. It also means that the raw materials consume time to convert into finished products ready to sell. Your funds will remain blocked until the product is sold and your need for working capital will be high.

3. The scale of operations of the business: A large organization will have high working capital requirements as compared to a small organization with limited employees and limited resources.

4. Sales made on credit and terms thereof: In the case of credit sales, you do not receive the money for goods sold immediately. This is when you need to have enough capital to keep the business running. If you are selling goods on credit, you need to mention the credit period and terms to the lender in your application. The bank will consider your requirement ability keeping the same in mind and will review the requirements for you.

5. Financial buffer for contingencies: Apart from the cash and bank balance, the lender will consider if you have any financial buffer for contingencies. You never know what situation might arise in the business, and you will need to put in cash to keep it running. Having a financial buffer for emergencies is a good sign.

After considering this, the bank will consider your profile before processing the loan. This means there are additional factors that the bank will review.

1. Credit score: Every lender considers the credit score as a way of estimating your ability to make the loan repayment on time. Your credit score will be considered before approving the working capital loan application. It is your creditworthiness and helps the lender make a decision. If you have a strong credit score, your application will be approved at the earliest.

2. Stability of the business: If you are a fairly new business with minimal assets and liabilities, the bank will consider whether you will be able to repay the loan on time or not. If you are a stable business with a strong history and profit-generating capacity, the lender will be confident about your ability to make the repayment and will approve the application.

3. Purpose of borrowing: Since the working capital loan is for the short term, you need to ensure that the purpose of borrowing is only to meet the financial needs. You cannot use these funds for long term investment or the purchase of an asset. The lender will ask you for the reason of borrowing and based on the same, and the application will be reviewed.

Keep this process in mind when making an application to the lender. You need to provide complete documents and information, as requested by the lender. A working capital loan can help your business thrive in peak season.
Indifi is a market leader in business loans and offers the best solutions to every size and type of business across different industries.