Different Types of WORKING CAPITAL Financing / Loans: CC/OD, BG, LC, WC Loans

Working capital is the difference between the organization current asset and its current liability. There are various types of working capital loans in India and in the international market available like trade credit, cash credit or bank overdraft, working capital loan, purchase of bills/discount of bills, bank guarantee, letter of credit, factoring, commercial paper, inter-corporate deposits etc.

Different Types of WORKING CAPITAL Loans. – LinkedIn

WORKING CAPITAL Financing - Loans

The arrangement of working capital is playing the vital role in any organization. It is the very important activity which requires much attention of the finance managers or an Entrepreneur.

why small business owner need working capital finance

The reason behind all this, working capital is the money which is an important need of the business in order to run its daily operational activities appropriately. Without sufficient sources of capital it is difficult of the survival of the organization.why small business owner need working capital finance

Because when there is no money, there is no concept of any business. When you have no cash on your hand, you are unable to pay your dues to your types of working capital financing or loancreditors or supplier. So your source of financing should be appropriate.

An inappropriate source of funding lead toward the uncertainty and loss to the organization.

What are different types of Working Capital financing?What are different types of Working Capital financing ?

Types of working capital finance provided by banks

Enlist below there are some working capital source of financing / Loan

Trade Credit:

Trade credit (TC) is the first source of financing in which business form an agreement with the supplier for the purchasing of goods. Or in other words it is an extension of credit period time by the creditor to its creditworthiness business customer on the basis of its earning records, liquidity position, and records of payments.

Types of Working Capital Loan - Trade Credit Loan

Types of Trade Credit

There different types of Trade credit like as under:

Promissory Note:

it is the written agreement between borrower and lender whereby the borrower received assets (normally Inventory) on credit and make promises to repay the purchase price (may be with some extra) in full or on installment at or before the specified period of time( or within one accounting period).

Open Account: 

This is a short time peiod agreement between business and supplier whereby the supplier offers a specific amount of linit of credit purchase to the business, and the business can transact multiple time on credit basis but within the available time.

  • parties are not bound to singed any note for each single transaction
  • life of the agreement varies from 1 month to 12 month and the maturity life is 3 months..

Cash Credit / Bank Overdraft

The second one and the most important source of funding is Cash Credit or Bank Overdraft used by the most of the small, medium and big business organizations. In this source of financing the Borrower approaches a commercial Banks and the borrower sanctioned a specific amount of cash for the sack of injecting in the business. In this way business make will be in the position to smoothly run its routine operations.Types of Working Capital Loan - Trade Credit Loan

The amount offered by the banks is sanctioned and the borrower is bound that he will not cross the sanctioned limits. The most interesting thing in this source of financing is that the interest will be charged only on the amount that you had used in your business, and not on all the sanctioned amount. There is no doubt that this is most effective source of Working capital financing.

Working Capital Loans

Working capital loans are also known as the term Loan for short Period. Businesses borrowed these types of loan to make its financing permanent working capital needs. At the end of the period, working capital loan will be in lump sum or in rapid installment.

Pledging of account Receivable / Purchase / Discount of Bills /

This is another good source of short-term secures working capital financing. In this type of financing the business organization uses the account receivable as a collateral/security for the sack of working capital finance by commercial banks

This is the 3rd step process as under:

  • Quality of Receivable is evaluated: it means the degree or possibility with which receivable will be converted into cash. if the receivable with 100% of quality will be able to make 90% amount of loan for the business. For example, 400,000 will be provided out of 500,000 on this criteria. The creditworthiness of the business client can be evaluated on the basis of 5Cs. At the maturity business will notify its account receivable to make payment to the bank on his behalf. Or collect the cash from account receivable and make payment to the bank itself.

Bank Guarantee

This is the non-fund based working capital source of financing. In such sources of financing the Buyer or seller approaches to the bank and acquire bank guarantee in order to reduce the risk / uncertainity or reducing the risk of loss from the opposite party which may be in the form of repaying money or some services. In case of non performance of the agreement Banks revoke the agreement.

Letter of Credit (LC)

This is also non-fund based WC source of financing. There is very little difference in between LC and Bank Guarantee. In case of Bank Guarantee on nonperformance of the agreement Banks revoke the agreement. But in case of Letter of Credit the buyer purchased the LC from the bank and send it to the seller and received the good as per agreement. The banks will pay the amount to the seller on behalf of buyer to the seller and collect then collect this amount from the buyer.

Factoring

The last one source of financing is “Factoring”. In this source of funding the business sell all of its or selected account receivable  to the third party on discount or at lower price. The party who are providing factoring services is called Factor. The Factor is third party organization whose responsibility would not only to provide the services of financing through selling the account receivable but also to collect the amount from the debtor as well.Recourse and Non Recourse Invoice Factor
There are two types of factoring:

  • factoring with recourse: if the credit risk of non-payment by the debtor is because of business it would be factoring with recourse.
  • Without recourse: if the credit risk of non-payment by the factor then it would be considered as without recourse.

What is Debt/Equity Ratio? Investopedia

Debt to Equity Ratio shows the percentage of the financing of the company which gain from creditor and investors.

What is Debt/Equity Ratio?

Debt/Equity  (D/E) ratio is equal to the number of total liabilities of the company divided by the shareholder of the company. For the evaluation of the company’s Leverage, these calculations are used. This ratio is also considered as a balance sheet ratio because of the balance sheet these all are calculated Debut/Equity ratio by the following formula.

Debt to Equity Ratio | Formula | Analysis | Example

Debt to Equity Ratio | Formula | Analysis | Example

It means that both investor and creditor have the same stake in the business assets. A business which is financially stable has the low Debt/Equity ratio.

Those companies which have High debt to Equity ratio are the more risky companies for investor and creditor both as compared to the companies which have low debt to equity ratio.

 

As Debt repaid to the lander, unlike equity financing. there is the debt servicing or the regular interest payment requirements for the debt financing because of which debt financing is more expensive than the equity financing.

It is in the knowledge of the creditor that high debt to equity ratio is very risky because the investor has not funded the operation as the creditor have.

In simple words, the mean of this is the investor has no interest to funds the company operation if the performance of the company is not good.

If the performance of the company is not good then the company need to seek out extra debt financing.

For more Financial Ratio Check: 

Debt service coverage ratio

Debt to asset ratio

Debt to capital

Working Capital Cycle: Definition | Example | Formula | Diagram | Phases

Working capital cycle

The Networking Capital refers to the total length of time that takes a business to convert its all net working capital including all the current assets and the current liability into cash.

What is a Working Capital Cycle?

In general most of the business complete this cycle by selling the inventory and to the customer and collection the amount of revenue from its routine customer, and then make settlement of payment with the passage of time.

Working Capital Cycle

Working Capital Cycle Diagram

Steps / Phases involved in the Working Capital Cycle (WCC)

For most companies, the working capital cycle works as follows:

  1. Purchase Raw material from the supplier on credit to make the finished goods. Suppose we have 90 days to make payment for raw material.
  2. In order to achieve the average company have to sell its inventory in 85 days,
  3. Collection of payment should be made from the customer with 20 days, on average.

According to the above Cycle, the company acquires the raw material from the supplier in order to make the finished good. At the very first time the company don’t have any cash expenses because the order had been made on a credit basis.

Working Capital Business Diagram

In 90 days, a company has to pay the amount for the material purchased. 85 days will take on assembling the raw material into finished good and sold to the customer. The finished good will be sold to the customer but the payment not yet received, and this will take further 20 days to collect the amount from debtors. Once cash received and payment to the supplier, the working capital cycle is complete.

Working Capital Cycle Formula

What is the formula for working capital

and How to calculate working capital Cycle ?

Based on the above steps, we can see that the working capital cycle formula is:

Working Capital Cycle Formula

WCC Formula

WORKING CAPITAL CYCLE CALCULATION

On the basis of the above information we can calculate the WCC as under:

Inventory days = 85

Receivable days = 20

Payable days = 90

Working Capital Cycle = 85 + 20 – 90 = 15

Positive vs Negative Working Capital Cycle

Positive Working Capital Cycle

it refers to the positive cash flow in the business and we consider that there is a normal cycle of working capital. In the above example, we saw a business with a positive, or normal, cycle of working capital.

Positive Working Capital Cycle

Normally positive WC is the exceeding of the current assets against the current liability of the business. You can also say that if there is a positive figure of Net Working capital, this will be considered as the positive Working capital. This is a very impressive solution for the company in all tough circumstances. It ensures the company to save it from bankruptcy.

Negative Working Capital Cycle

Sometimes, however, businesses enjoy a negative working capital cycle where they collect money faster than they pay off bills.

Negative Working Capital

Negative working capital is the reverse of Positive Working Capital. In NWC there is an excess of current liability over current assets. This can also be said Negative net working capital. In this case business financed its liability 100% from the current assets and also some portion from the fixed assets.

Sticking with the example mention before if the organization decided to make transaction only on cash basis then in this case there will be no account receivable days.

In this scenario we can calculate with the same formula:

Inventory days = 85

Receivable days = 0

Payable days = 90

Working Capital Cycle = 85 + 0 – 90 = –5

Now company just sell the product and received the payment and give it to the suppliers.

Days Working Capital Formula

Financing Growth and Working Capital

With the positive cycles, most of the Business Organizations normally require financing in those period of time when they sell out the product to the customer but the payment yet not collect. This is the smart idea and also the reason behind the success of rapid growing companies.

In order to manage this situation companies approach to the lending institution to have financing. those lending institutions like bank normally lend money against some securities like inventory and also in some condition on the basis of account receivables.

working capital cycle example

We can understand this scenario with the help of the example:

Let suppose if the lending institute like Banks believes that your company is capable to convert its current assets into cash at 70% then it is possible that you may receive loan upto 50 % of the cost of your inventory.

Furthermore in other cases, if company apply for the loan on the basis of highly credit-worthy account receivables the bank may finance those receivables (also called “factoring”).

Additionally, if a company sells products to businesses that have high creditworthiness, the bank may finance those receivables (also called “Factoring”) by providing early payment.

With the help of anyone or both of the banking solution. A company can finance its capital to operate its routine operations.

 

Return On Equity Ratio | ROE Ratio | Example | Ratio Calculation | Formula

The ability of the company or the firm that generate the profit from the investment of shareholder is called Return on Equity (ROE) ratio. In simple words, we can say how much profit generated from the single stockholder equity.Return On Equity Ratio

If ROE is 1 then it means that the Equity of common stockholder generates 1 dollar from net income. From this investor can see that the firm use money for the generation of net income in a better way or not. So for the potential investor, it is necessary to know ROE in this way.

Return on equity is the way from which investor indicate the management that hoe effectively management use the Equity financing for the funds’ operation and for the growing of the company.

Formula

The return on equity ratio formula is equal to the Net income divided by the Shareholder’s equity. that is

 

Mostly for the common shareholder ROE is used. In the calculation of this ratio preffered dividend not include because of this profit not for the common stockholder.

So the calculation of the preferred dividend taken out from the net income.

There is also the equity of the average common stockholders’ use for which the beginning and ending Equity calculation is necessary.

Analysis

Return on the equity measures that the firm progress that the firm generated how much profit for the investor who invests in the firm.

It means that ROE is the profitability for the investor not for the firm. So ROE is used for the calculation of the money for the investor which investor make from the firm.

It does not tell the profit of the firm or about the firm’s assets.

When investors want to invest in the company that first of all investor want the high return on the equity ratio. Because of which it indicates that the company use the funds of investor effectively and make money. The high ratio is better than the low return on equity ratio.

For every company, there are different levels for investor and income. Through ROE investors cannot compare the company outside of their industries effectively.

When users invest in the company that first of all investor calculate the return on equity at the beginning and at the end to see the return. From this investor see the trend of the company.

Example

There is John’s tools company. It sells tools to construction company within the country. his net income is $200,000 and its issued preferred dividends of 20,000 during the year. John also had 20,000, $5 per common share during the year. Then the return of common equity of John is that

Return on Equity Ratio

1.80= (200,000-20,000)/(20,000×5)

From the above result, it is clear that when the preferred dividends remove from the total income John’s ROE remains 1.80. It shows that every dollar of the Equity of the common shareholder earns 1.80 $ in his year. So we can say that the shareholder gets the 180% return of their investment. which shows the company of John is the growing company.

If the investor wants to check the growth of any company then for this investor get the average ROE ratio of 5 to 10 years of the company.