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Working capital requirement is the funds required to meet the recurring expenses of a business. Such expenses include electricity bills, rent, employee wages, etc. Working capital can be found by subtracting a firm’s current liabilities from its current assets.
A deficit in working capital can lead to several problems, bankruptcy being one the worst case ones. Hence, firms opt for external funding to stay resistant to such situations.
There are many sources of working capital. However, you must determine the needs of your business before choosing a source.
Before learning about the sources, you must learn about the two policies that business managers use while financing working capital needs of a business. They are:
- Aggressive strategy: In this strategy, a manager uses short term loans to finance the working capital needs of the business. This strategy is more applicable in cases of seasonal businesses.
- Conservative strategy: In this one, a manager depends on long term sources of finance for working capital requirements. It is one of the more dependable sources of working capital finance for companies that face uniform demand throughout the year.
Once you understand these two strategies that businessmen generally use, you will be able to determine why you should use working capital loan to fund your business.
The sources of working capital can be broadly classified into two categories. They are:
1- Internal sources – These sources generally consist of reserves and provisions held within the business. Examples:
- Retained profits
- Depreciation provision
- General reserves
- Provision for dividend2- External sources – These are the most popular source of working capital loan and will be given the most attention in this article. Examples:
- Overdraft
- Public deposits
- Long term loans
5 external sources of working capital finance:
Medium and small enterprises generally do not hold enough reserves and provisions to be able to finance their working capital requirements. Therefore, they have to rely on external sources.
- Short-term loans: There are many financial institutions and companies that offer a short-term working capital loan for such needs of a business. It is the most popular method of generating liquidity as these loans are quickly available and ideal for aggressive strategists. Whenever, you think that your business is not qualifying line of credit. You can opt for short term loan. The benefit here is, if you become successful to have a good relationship with banking institutions, you can apply for another more loans as trusted customers.
- Public Deposits: Companies Act 1963 has provisioned for companies to raise finance by accepting public deposits. It mainly invites shareholders from within the employees of the company and the general public to deposit their savings with the company. This is generally done through advertising in mass media. The public are attracted by the promise of delivering higher returns than the prevailing investment plans. However, you will have to understand how much working capital your business needs.
- Debentures: Debentures are loans accepted from public. These are considered long term unsecured debts and charge a fixed rate of interest. They can be redeemable and non-redeemable debentures. The investors have to depend on the credit worthiness of the business as there are generally no collateral. A company with debentures is considered a highly levered.
- Bill discounting: Many companies have high number of pending bills. It means that it has a high debtor turnover period. In case the company requires funds for working capital, they can discount their bills with a lending institution. The institution charges an interest rate before, forwarding funds against the unpaid bill. It is an easy source of business loan to finance working capital requirements.
Other than the above, there are several other sources of external funding. Peer-to-peer (P2P) lending is one of them that is gradually becoming more and more popular in India.
