What Is The Importance Of Working Capital Finance For Businesses?

Businesses, both big and small, have many day-to-day expenses. Even if one is running a profitable small business or startup or whether one is a self-employed professional, one may still require working capital to meet the gap between cash inflows and outflows. This is because payment cycles differ from suppliers or vendors and buyers or customers.

In simple terms, working capital covers short-term payment obligations of businesses that cannot be matched to immediate payments from customers and thereby, revenues.

The Need For Working Capital

Cash flows for many businesses have seasonality and establishments may require extra capital to prepare for the busy season or to keep the business operating when there’s less money coming in.

Almost all businesses will encounter periods when additional money is needed to fund immediate obligations to vendors, employees and for government taxes while waiting for payments from customers.

At the same time, small businesses also pick up additional supplies from vendors to get a bulk discount even when it is well understood that the entire product or the processed product cannot then be sold to the final customers in the same period.

How To Figure Out Working Capital Needs

One can gauge the requirement for working capital by calculating the working capital ratio. This is nothing but a ratio of the current assets and current liabilities.

If one has a working capital ratio of over 2, it is considered healthy. However, this ratio differs from sector to sector and, thereby, company to company. In some cases, even if this ratio is just over 1.2, it is considered healthy enough.

Net working capital, which is excess of current assets over current liabilities, indicates how much money the company has for meeting current expenses. This captures the surplus of short-term assets such as cash in the business account, the accounts receivable and the inventory expected to generate cash in the near term, against short-term liabilities such as money payable to vendors and other creditors and fixed expenses for salary and taxes.

Getting an accurate picture of the working capital requirement would involve placing month-by-month inflows and outflows for a business. This would not be and need not be absolutely accurate but should be good enough to give a profile of cash to be borrowed to meet the seasonal or other short-term requirements.

When the net working capital is in the negative, it can be bridged for smooth operations of a business via working capital finance.

Financing Working Capital

A working capital loan is a short-term business loan to meet immediate cash needs that can be repaid within a year, though in some cases it could be for a longer tenure. These can take the form of secured or unsecured loans, as well as an overdraft.

One should not mix short-term and long-term capital requirements. For instance, if a business needs capital for the long term to establish a new production unit, it should not bank on a working capital loan to meet the expense.

This is because long-term business loans carry a lower rate of interest and have a longer tenure.

Most lenders have created working capital loan products to cater to specific needs and to meet the working capital requirements of small businesses in particular.

Smart management of working capital needs with loans that can help meet the requirement without adding to long-term financing cost is important for businesses.

Types Of Working Capital

Working capital finance can take various forms, including a pre-approved withdrawal limit with an overdraft on the business current account; loan on account receivables from long-standing credible customers; factoring to monetize receivables at a discount; and short-term loans.

Some lenders may want to offer secured working capital loans, while many others offer unsecured short-term loans to finance the immediate working capital requirements. Between the two, unsecured working capital loans carry a higher interest compared to collateral-backed working capital loans.

Depending on the status of the business establishment and its asset base, one can opt for either product. For service-led businesses that do not have physical assets, an unsecured short-term loan is often the best way to cater to working capital needs.

Conclusion

Businesses, especially small and medium-sized establishments, need to match their short-term cash inflows with outflows to streamline their finances for smooth operations. They can achieve this via working capital finance with short-term business loans.

While almost all banks and most non-bank lenders offer working capital loans, you should approach a reputed lender that offers great service, an easier approval process, and greater flexibility in repayment.

IIFL Finance, for instance, offers customized working capital solutions to small businesses. In particular, it offers fast, flexible and hassle-free working capital loans designed specifically for e-commerce merchants. It does this via its Digital Finance program, via a collaboration with e-commerce portals, aggregators, fintech companies to offer financial solutions to their merchants.