In the current financial year, businesses are expected to require Rs 11.2 lakh crore in working capital, up from Rs 8.7 lakh crore in the previous year. As a result, businesses will need more capital to meet their operational expenses, such as inventory purchases, salaries, and other expenses. As the lending sector becomes increasingly competitive, it is also crucial for lenders to understand the importance of risk assessment in working capital lending.
In this article, we will discuss the meaning of risk assessment in working capital and the best practices and pitfalls to avoid when assessing risk in working capital lending.
What Is Working Capital?
Working capital is the amount of money needed to run a firm on a daily basis, such as paying for goods, employees, rent, and other operating expenses. It is the sum of a company’s current assets and current liabilities.
Cash, accounts receivable, inventory, and other short-term assets comprise a company’s current assets, while current liabilities comprise accounts payable, short-term loans, and other debts due within one year.
Working capital lending is borrowing funds to support a company’s short-term operational needs, such as wages, rent, and inventory purchases.
Why Do We Need Working Capital Loans?
Here are some of the reasons why working capital lending is necessary:
Managing cash flow
Cash flow changes are expected in businesses due to a variety of factors such as seasonality, economic cycles, and unanticipated expenses. Working capital lending assists businesses in managing their cash flow by giving access to funds when needed.
As they expand, businesses may need to invest in additional inventory, equipment, or personnel. Working capital lending assists in financing these expenses, allowing businesses to develop without depleting their cash reserves.
Keeping operations running
Unexpected expenses or a decrease in revenue may occur in various instances. Working capital lending helps bridge the gap between income and expenses, allowing firms to continue operating despite tough times.
Avoiding cash shortages
Businesses that lack sufficient operating capital may struggle to pay their payments on time, resulting in late fees, penalties, and lowered credit scores. Working capital lending allows businesses to avoid cash constraints and maintain a solid financial status.
How Does Risk Assessment Work in Working Capital Lending?
Risk assessment in working capital lending is the process of evaluating a borrower’s creditworthiness and determining the possibility of payback of a loan used to finance the company’s operations.
The assessment examines several aspects that may affect the borrower’s capacity to repay the loan, including their financial situation, credit history, collateral, and industry/market trends.
Risk assessment aims to assist the lender in determining the right amount of credit to issue to the borrower and to reduce the chance of default.
A lender, for example, may utilise risk assessment to examine a small firm that requires a loan to purchase inventory. To estimate the likelihood of repayment, the lender may examine the company’s financial statements, credit history, and industry/market trends.
What Are the Best Practices for Risk Assessment in Working Capital Lending?
Working capital loan risk assessment is a process that evaluates a borrower’s creditworthiness and determines the right amount of credit to offer.
The steps involved in risk assessment in working capital financing are as follows:
The first phase in the risk assessment process is to screen the borrower to see if they match the lender’s basic eligibility requirements. Verifying their identity, business registration, and creditworthiness are all part of this process.
The lender then gathers information on the borrower’s financial situation, credit history, collateral, and industry/market trends. Examining financial documents, credit reports, and collateral values is part of this process. In addition, the lender may undertake site visits and interviews with the borrower’s employees.
Lenders analyse the borrower’s creditworthiness, credit scores, collateral values, and industry/market trends to evaluate the borrower’s creditworthiness and potential risks. Additionally, the lender assesses the borrower’s ability to generate cash flows and repay the loan.
Based on the risk analysis, the lender makes a credit decision on whether to approve or deny the loan application. If the loan is accepted, the lender calculates the right amount of credit to offer and the loan’s terms and conditions.
Monitoring and Reporting
Once the loan has been disbursed, the lender will conduct continuous monitoring and reporting to ensure that the borrower is abiding by the loan’s terms and conditions.
Examining financial documents, credit reports, and collateral values is part of this process. The lender also monitors the borrower’s credit history and any changes in their financial situation.
The overall risk assessment in working capital lending involves gathering and analysing data to determine a borrower’s creditworthiness.
Avoid These Common Risk Assessment Pitfalls in Working Capital Lending
In the lending industry, risk assessment is critical to working capital lending, but if not conducted thoroughly, it can lead to significant pitfalls, including:
Over-reliance on collateral
To secure the loan, the lender should not rely primarily on collateral. In the event of a default, collateral may not be adequate to cover the loan amount.
Ignoring market and industry trends
The lender should not overlook market and industry trends. Failure to consider industry and market developments may result in lending to a company with limited future possibilities.
Inadequate financial statement analysis
The lender should not depend simply on the borrower’s financial statements without undertaking a thorough examination. Inadequate analysis may result in a loan being made to a company that cannot repay it.
Failure to undertake site visits
Without site visits, the lender should not depend exclusively on the borrower’s financial statements. Site visits allow you to learn about the borrower’s operations and management procedures.
Risk assessment in working capital lending is critical for lenders to ensure timely repayment of loans. Analysing the borrower’s financial accounts and reviewing the borrower’s credit history are effective practices for risk assessment. Effective risk assessment strategies can help prevent defaults and reduce losses for lenders.
Fintech tools can help in risk assessment by leveraging advanced algorithms and machine learning techniques to analyse large amounts of data, identify trends and patterns, and generate insights that can help lenders make informed decisions.
Finezza is a fintech tool that offers risk management services to banks and NBFCs, enabling them to offer their customers a complete, fast, and error-free lending solution. Providing end-to-end loan management and credit evaluation solutions for lending businesses,
Finezza’s advanced document identification and verification capabilities you can easily extract information from verification documents such as PAN cards, balance sheets, and much more. In addition to saving time, this automated feature increases workflow speed with no chance of human error.
Hence, financial institutions can better anticipate financial and non-financial risks, such as strategic, funding, legal, political, etc.
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