Working Capital is a financial metric that, despite its technical definition, is better understood in the literal sense of the term which is, ‘the capital that works’. As a production factor, it generates revenue and ensures the continued existence of the other three aspects, such as labour, land, and entrepreneurship.
Working capital management entails controlling liquidity by balancing cash flows. It is a function that determines the survival of small businesses and startups in particular. Businesses have two options for generating necessary working capital: internally generated or externally sourced funds. To meet liquidity requirements, they can either reinvest business revenue in production or rely on external funding such as working capital loans.
In the early days, startups rarely generate enough revenue to fund their operations, leaving loans as the only viable source of working capital funding.
Let us delve deeper into the topic.
Working Capital: Revisiting the Fundamentals
Working capital is defined as the surplus of a company’s current assets over its current liabilities. A positive working capital indicates that the company has enough liquidity to meet its short-term obligations, whereas a negative working capital suggests a possible cash shortage.
A firm’s working capital requirement is determined by the following:
1. Business type
Compared to service-based industries that generate intangible products, manufacturing firms will have higher overhead costs and cash requirements due to physical inventories.
2. Operating cycle
The more “time-to-market” a product has, the more working capital the company will need. This holds true for service businesses that bill the clients after providing the service rather than securing upfront payments.
3. Business objectives
Whether the business wants to scale or maintain the current size of operations, its working capital needs will vary. If the company wants to expand its product line or enter new markets, it will need more research, development, and marketing funds.
Whatever the requirement, fledgling companies can rely on working capital loans to finance their immediate requirements or create a buffer for periods when there are fewer cash inflows.
What is a Working Capital Loan and Why do Startups Need it?
A working capital loan bridges the gap between a company’s receivables and payables. It enables businesses to run their day-to-day operations smoothly until their clients make payments. Also, it helps to cover recurring expenses like wages and salaries, rent, etc. and is not meant to fund the firm’s capital expenditures. Working capital loans have shorter repayment tenure and higher interest rates and can be either secured or unsecured.
When a company looks for outside funding to cover its operating expenses, it has two options. One method is offering equity to private investors such as angel investors or venture capital firms. The other is by availing loans to secure operating capital. Between the two methods, working capital loans offer more benefits for startups.
Advantages of Working Capital Loans
Here are a few benefits of working capital loans that startups can avail of:
- Simple and faster access compared to equity funding.
- No dilution of control in the firm as a result of equity sharing.
- Continuous access to cash in the form of lines of credit or overdrafts
- Lenders can offer repayment terms that correspond to the cash inflows of seasonal and cyclical businesses. This reduces firms’ repayment burden during non-operational months.
- Helps in inventory management by facilitating bulk purchases that offer discounts and fund inventory costs such as warehouse rents, insurance costs, and cost of shipping, etc.
- Help in developing better partnerships with suppliers and clients. With sufficient working capital, businesses can pay their suppliers promptly and sometimes benefit from the discounts offered on upfront payments. Furthermore, they can offer extended credit periods to their customers without worrying about meeting expenditures.
Different Types of Working Capital Loans
From simple pre-approved credit limits for the firm’s current account to specialised trade finance facilities, various working capital loans are available that match the specific needs of any business. Some of these include,
- Line of credit/ Overdraft– This is a flexible cash facility wherein the businesses can draw from up to pre-approved limits. Firms can withdraw any amount up to the threshold limit, depending on their needs. Usually, the eligible working capital limit is calculated based on the stock or accounts receivables.
- Term Loans – Term loans are working capital finance extended for a shorter period, typically less than a year. Repayments must be made in fixed, regular instalments.
- Accounts Receivables Financing and Factoring– These types of working capital funding are appropriate for businesses that do a lot of invoicing. Lenders loan money to businesses based on outstanding invoices.The fundamental difference between receivables financing/ invoice financing and factoring lies in the treatment of invoices. In receivables financing, such invoices are used as security, whereas factoring involves selling unpaid invoices to lenders.
- Peer-to-Peer (P2P) Lending– Peer-to-peer loans are digital loans based on the crowd-funding model of financing and use online applications to connect borrowers and lenders. In India, the maximum amount that a single borrower can avail at a time through all P2P platforms is Rs.10 lakhs.
- Business Credit Cards– Corporate credit cards are another attractive alternative source of working capital finance. Using a credit card for business purchases helps to build the startup’s credit score.
Richard Branson once said-“Never take your eyes off the cash flow because it is the lifeblood of business”. If one applies the same analogy, working capital management becomes the circulatory system for the business. Rightly so, it is a measure of a company’s liquidity, operational effectiveness, and budget management, and consequently, its short-term financial health.
The shortage of capital is a major reason why many startups fail. A study conducted recently found that 47% of startup failures in 2022 happened due to a lack of financing and 44% due to funds being dried up. When access to working capital is limited in the bootstrapping days, it is sensible to turn to working capital loans to stabilise the cash flows.
This is why Finezza brings end-to-end loan management solutions and credit evaluation services to lending businesses. Our platform supports all administrative tasks involved in lending, from loan origination to NPA management.
Contact us today to learn more about our products.