MSMEs often face working capital shortages due to irregular cash flows, seasonal demand fluctuations, and delayed customer payments. Working capital loans help bridge these shortages, helping MSMEs manage day-to-day operational expenses, ensure smooth cash flow, maintain inventory, meet payroll, and manage unforeseen expenses. In short, working capital financing ensures access to short-term funds to keep operations running smoothly. If you are an MSME owner looking to secure a working capital loan to meet urgent cash flow requirements, this guide is for you.
What is a Working Capital Loan?
Working capital loan is a type of business loan designed to offer financial support to enterprises for their day-to-day activities. It is a type of loan that covers various operational expenses and overheads like wages and salaries of employees, accounts payable, and other short-term financial obligations. Working capital loans are ideal short-term financing solutions for periods when the enterprise faces lower business activity. Working capital financing is not intended to be used for business expansion activities or for purchasing long-term assets like machinery. Instead, working capital loans serve short-term financing needs by helping businesses meet their present operational cash flow requirements.
Factors to Consider When Choosing a Working Capital Loan
When choosing a working capital loan to for your business, you need to consider the following factors:
- Loan amount: The first step in securing working capital financing is determining your loan requirement. This entails estimating the exact amount of funds required to cover the short-term financial obligations of your business. Consider the purpose of the loan to estimate the exact amount of capital required. For instance, if you plan on using the funds to cover payroll expenses, calculate the payroll period and all payroll components.
- Interest rates: Interest rates on working capital loans vary from one financial institution to the next. Compare interest rates before applying for the loan to ensure you obtain the credit at the most competitive rates.
- Fees and charges: Working capital loans also come with allied fees and charges, such as processing fees and late payment penalties that can potentially increase your overall cost of borrowing. Make sure you research these add-on charges carefully to avoid any sudden shocks later.
- Lender reputation: If you are trying to secure working capital financing, you should spend some time researching lenders as well. Applying to a lender with a good reputation and customer reviewers can help make the application and loan management process easier.
- Loan type: There are various types of working capital loans available in the market, each designed to meet specific needs and goals. Understanding the different types of working capital financing available can help you make an informed choice:
- Overdraft – Overdrafts or cash credit is one of the most common types of working capital financing. Here, the lender sanctions a cash loan for the business. The business owner can borrow the capital as and when needed from the overdraft account up to the pre-approved overdraft limit and meet short-term obligations.
- Invoice financing – Invoice financing allows you to acquire the required cash by selling unpaid invoices to the financial institution at a discounted rate. However, the entire outstanding invoice amount is collected by the lender from the debtor.
- Bank guarantee – A bank guarantee essentially assures the beneficiary that the bank is liable to meet the financial obligation of the applicant if they fail to do so.
- Letter of Credit – A letter of credit is another type of payment guarantee that ensures that the seller will receive payment in full once they meet the terms and conditions outlined in the letter.
- Repayment term: Evaluate the financial standing of your business and choose a repayment tenure that best aligns with your payment capacities.
- Collateral requirement: While most working capital loans are unsecured, some lenders also offer secured working capital financing. Collateral options can include properties, gold, securities, or the business itself. If you are opting for a secured loan, ensure that you own the types of assets acceptable as collateral.
- Application process: Pay attention to the application process. If your business requires immediate working capital funding, choose lenders that offer instant loans. Traditional lenders like banks can take anywhere between a few days to weeks to process your loan application. Therefore, it may be prudent to explore other options like NBFCs and new-age Fintechs.
Tips for Negotiating Better Loan Terms and Securing the Loan Faster
Availing working capital loans with favourable terms is crucial to keep your repayments manageable and avoid overburdening your business finances. Here’s a few easy tips you can use to negotiate better loan terms and secure the loan faster:
- Leverage your creditworthiness: Maintaining a good credit score of 750 and above can help you negotiate better interest rates for your business loan.
- Demonstrate profitability: Lenders are generally willing to sanction working capital credit against favourable terms to businesses with strong financials. Provide evidence of a steady cash flow and revenue to get access to credit on favourable terms.
- Submit all the required documents: Most lenders require a set of documents to confirm your eligibility. This generally includes proof of business ownership, financial statements, bank statements, and tax records along with your KYC documents. Review the list of documents needed by your selected lender carefully. Providing all the required documents promptly can expedite the loan approval process.
Conclusion
Working capital loans are crucial for businesses faced with short-term cash crunches. Obtaining working capital financing helps businesses remain afloat during periods of lower revenue. MSMEs can choose from various types of working capital loans including cash credit, invoice financing, letter of credit, and bank guarantees to ensure optimal cash flow management, maintain operational efficiency, and meet short-term obligations. However, before deciding they must consider factors like loan amount, tenure, interest rates, and the application process to gain access to low-cost credit at the earliest.