Retail is a capital-intensive business, and with large retail players constantly expanding their market footprint, smaller retailers are always in a need to expand into new products, categories and aggressive customer acquisition to build turnover. Dealing with difficult suppliers, uncompromising consumers shifting to competitors every second is making managing working capital increasingly difficult for small retailers in India. In this article, we will discuss some of the most common ways of funding the working capital. They are:
- Extending Credit Period
- Overdraft Account
- Invoice/Bill Discounting
- Bank Guarantee (BG)
- Letter of Credit (LC)
- Receivables Loan/Factoring
Extending Credit Period
When you extend credit period with your suppliers, you directly add that days of working capital to your business. It is probably the best way to add working capital to business.
Overdraft account is an account that you can open in a bank against your business. Bank will look into the business turnover, audited financials (balance sheet and PNL), purchase orders upcoming, invoice history, etc. and decides a credit limit for the account. So, this account is like a regular (credit card) account with a certain credit limit. However, the difference is there won’t be any regular EMIs or minimum payment every month (unlike a credit card) and instead you can pay cumulatively and clear the dues. Whatever credit you use, the interest rate (9-10%) for that will be applicable for the duration until due clearance. This facility is very useful to business and almost all businesses run on OD accounts. However, the OD facility is ideally supposed to be used only for the purchase of raw-material and turning them into production. So, banks can come and audit for the raw-material and in-process and finished goods inventory at any point of time and the business owner shouldn’t cheat the bank by using this money for other purposes. OD accounts are of many types such as OD account against house, OD account against fixed deposits, OD account against receivables, fixed assets, turnover, etc. and the OD account sits as a loan in the balance sheet against which there is an interest expense in the PNL.
This method is used by suppliers only when there is a dire need for capital. If you raise an invoice of Rs.100 to a party and you expect the money to come after 2 months. Then you can meanwhile get Rs.97 or Rs.98 from other parties in the market at a nominal fees of 3% or 2%. Typically, the rates are about 1.2% -1.5% per month (14.4%-18% per annum) in India. However, the con is this will eat away into your margin and it gets difficult if the business is running on thin margins. This is useful if the cost of capital for you is higher than the rate charged or when you are in desperate need for capital to drive growth of your business. However, the disadvantage is it sits on your balance sheet as a loan against which there is an interest expense in the PNL. Invoice Discounting is for the working capital after selling the goods to a buyer and OD Account is for the working capital requirement to buy raw-material and get that finished product ready.
Bank Guarantee (BG)
Bank guarantee is acquired by a buyer or seller as an insurance against the risk of loss to the opposite party due to problem in the agreed transaction, say not paying the due money on time or providing of some services etc. A buyer ‘Buyer X’ is buying some products from seller ‘Seller X’. In this case, ‘Buyer X’ acquires a BG from the bank and gives it to ‘SellerX’ to save him from the risk of nonpayment. Similarly, if ‘Seller X’ can also acquire a BG and give it to ‘Buyer X’ to save him from the risk of getting lower quality goods or late delivery of goods, and other risks. In essence, a bank guarantee is only executed by the holder only in the case of non-performance by the other party. Bank charges some commission for same and may also ask for security. This in turn helps in extending credit terms. So, if you are operating under the security of BG with a supplier, you can extend the credit terms for a longer period as there is no issue for the supplier too. The supplier in turn gets an OD or liquidates the BG with another party at a nominal rate and gets his working capital.
Letter of Credit (LC) (vs. BG)
LC and BG are similar in what they guarantee and are exactly opposite in how they get executed. Bank guarantee is acquired by a buyer or seller to reduce the risk of loss to the opposite party due to non-performance of the agreed transaction such as paying money on time or providing quality services, etc. Say, a buyer ‘Buyer X’ is buying some products from seller ‘Seller X’. In this case, ‘Buyer X’ may acquire a BG from the bank and give it to ‘Seller X’ to save him from the risk of nonpayment. Bank guarantee is revoked and the bank makes payment to the holder in case of non-performance of the opposite party whereas, in the case of a letter of credit, the bank will pay the opposite party as soon as the party performs as per agreed terms. So, a buyer would buy a letter of credit and send it to the seller. As soon as the agreed transaction is done, the supplier can liquidate the LC upon agreed terms.
Account Receivables Loan or Factoring
Accounts receivable are one of the most liquid assets any firm holds. A business sells all or a part of their accounts receivables to a another party at a price lower than the realizable value of those accounts. The third party here is called as the ‘factor’ who provides factoring services to businesses. The factor would not only provide financing by purchasing the accounts but also collects the amount from the debtors.
Hope this is helpful!