Small and Medium Enterprises (SME) and Micro, Small and Medium Enterprises (MSME) are the backbone of India in terms of not only providing employment but also aiding in the growth and development of the country’s economy. Any business requires a stable and steady flow of working capital for the smooth and efficient running of its day-to-day operations.
Most companies need working capital loans from time to time when they don’t have sufficient cash on hand or assets to liquidate. For example, the manufacturing industry does not have a stable revenue throughout the year; they face reduced business activity as a result of cyclical sales which are dependent on the requirements of the retailers. During a drop in sales, manufacturers need working capital finance to cover their short-term operational expenses. These expenses can range from rent and payroll to tax and debt payments.
Types Of Working Capital Loans
Now that we know why working capital loans are the need of the hour, let’s find out what are the types of working capital loans available to SMEs and MSMEs in India. The 4 major working capital financing options are term loans, business credit cards, trade credit, and invoice financing.
- Term Loan: This type of loan is best suited to cover sudden and unexpected business expenses. Usually, these are loans with a short duration and a fixed interest rate. The lender decides the tenure of the loan depending on the borrower’s business needs. Mostly, term loans are secured loans but if a business has an impressive credit rating and a good history with the lender, an unsecured loan can be obtained without any collateral.
- Business Credit Cards: Commercial banks offer business credit cards with an array of features and benefits. This type of credit card provides access to working capital financing. Companies are given a specific spending limit on the cards and are required to pay interest only on the amount spent.
- Trade Credit: It is the most convenient option of short-term working capital financing and the least expensive one. It is a business-to-business (B2B) agreement wherein the buyer can obtain supplies from the supplier without paying upfront; the supplier will be paid at a later date (ranging from 30 to 90 days) once the buyer has manufactured and sold the goods. What’s more, the buyer doesn’t have to pay interest for this type of credit.
- Invoice Financing: In this form of financing, businesses can borrow against customers’ unpaid invoices to cover cash flow gaps when customers take a long time to pay for goods and services. The lenders will deduct a percentage of the invoice as service fees. is a convenient alternative when other types of business credit are difficult to secure.
How To Apply For Working Capital Finance?
Companies have to be in business for at least a year to be eligible for working capital loans. Lenders like banks and non-banking financial institutions will check the borrower’s credit history, credit rating, trading history, financial strength, assets, liabilities, income, and profitability while reviewing the loan application. Therefore, business owners will have to check their loan eligibility before applying for working capital finance.
Documents Required to Obtain Working Capital Financing
- Identity, income, and address proofs
- PAN card
- Passport-size photographs
- Partnership deed
- Certificate of registration and certificate of incorporation
- Income statement and Income Tax Returns (ITR) of the last 3 years
- Financial audit reports of the last 2 years
- Memorandum of Association (MoA) and Articles of Association (AOA)
- Credit Monitoring Arrangement (CMA) report, if needed
- Last one year’s loan statement with sanction letters including those from other credit institutions
- Company letterhead containing names of all existing directors
Advantages and Disadvantages of Working Capital Loans
|Business owners have easy and quick access to working capital finance for covering their companies’ short-term operational financing needs.||Working capital loans are sometimes tied to a business owner’s personal credit, therefore, in case of delayed or missed payments, his or her personal credit score will be negatively affected.|
|In the case of an unsecured working capital loan, a company can secure the loan without putting down any collateral.||Only companies with a high credit rating are eligible for unsecured business loans. Those with a poor credit rating will have to put down asset(s) as collateral to secure working capital finance.|
|Unsecured working capital loans allow business owners to maintain control of their companies even when they are in dire need of financing.||To compensate for credit risks, the borrowers will be charged high-interest rates which is a definite drawback for business owners; as the debt burden increases, the chances of defaulting on payments are higher.|
Even with the considerable drawbacks, working capital loans are the need of the hour when businesses are faced with a financial crisis. Companies with good credit ratings don’t have to put down any collateral to secure working capital financing. Likewise, short-term loan borrowers don’t have to worry about long-term EMIs. Companies involved in seasonal businesses can cover their daily operational expenses during lean periods with working capital finance. What’s more, working capital financing can be used not only for day-to-day operational needs but also for investing in future business operations. Although there aren’t any restrictions on how the funds are used, it’s advisable to use it for valid business needs only.