What oxygen is to fish, working capital is to entrepreneurs. You need it to stay afloat. Until you’re able to cover your expenses from the revenue you earn, working capital is what helps you pay your rent, salaries, marketing expenses and other day-to-day disbursals
That’s why, you need adequate and timely working capital financing.
Banks offer working capital to entrepreneurs in the form of five different instruments:
Line of Credit: It is an arrangement between the bank and the customer that establishes a maximum loan limit for the borrower. You can draw down on the line of credit at any time, as long as you do not exceed the maximum set in the agreement. This loan can be secured or unsecured in nature.
Accounts Receivable Loan: This is a type of loan that is secured by accounts receivable. That means banks provide short-term financing to businesses by selling their trade receivables or pledging receivables as collateral for a loan. The loan amount is based on a percentage of accounts receivable.
Factoring - This involves sale of account receivables to a third party collector. And unlike in the case of accounts receivable loan, here the factor bears collection risk.
Inventory Loan - In this type of loan, the bank allows the borrower to draw loan against inventory. That means the loan amount here is secured against the inventory held by the borrower. The loan amount is based on a percentage of inventory value. The lender receives security interest in inventory and may take physical control.
Term Loan: It is generally a medium term loan with a typical term of three to seven years. In this type of loan, the loan amount is tied to the collateral value. Here the principal can be repaid over several years based on a
Lack of adequate working capital is often stated as one of the major reasons for sickness in industry (especially in case of SMEs). However, as per an SBI bank official, “the counter argument of banks is that most firms face problems of inadequate working capital due to credit indiscipline (diversion of working capital to meet long term requirements or to acquire other fixed assets).”
How do banks compute the working capital requirement of a business and the quantum of financing?
6 Key Deciding Factors
Factors such as seasonality of raw materials or of demand may require that the company maintain a high level of inventory. Similarly, industry norms of credit allowed to buyers determine the level of debtors of the company in the normal course of business.
2. Level of Activity
Inventories and receivables are normally expressed as a multiple of a day’s production or sale. Hence, the higher the level of activity, the higher the quantum of inventory, receivables and thereby working capital requirement of the business. Banks often adopt industry standard norms for capacity utilization in the initial years of a business. Thereafter its previous performance is taken as the base.
While assessing the working capital requirement of a borrower, the bank also studies how the borrower has maintained current assets and current liabilities, along with the industry average. So while preparing the estimate of working capital requirement, a borrower should not deviate too much from the past figures because that can make it difficult to justify his request. Further, if there is a variation in requirements in future, such as increase in holding period, then the borrower should justify it with sufficient reasons and convincing evidence.
The borrower should remember that banks don’t generally finance receivables beyond a period of 90 days. In some exceptional cases the period may be extended upto 180 days.
The inventory should not contain old and unserviceable stock as the banker does not consider them while determining the drawing power.
6. Current Ratio
The current ratio is a measure of a firm’s ability to meet its short-term obligations. It is calculated by dividing current assets by current liabilities. Both variables are shown on the balance sheet. Banks require the current ratio to be maintained on an average at 1.33:1. In exceptional cases, a current ratio in the range of 1.20:1 to 1.33:1 may also be considered.
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