Working capital limits refer to the maximum amount of short-term financing or credit that a financial institution, such as a bank, extends to a business to cover its day-to-day operational expenses and short-term liabilities. These limits are established based on an assessment of the company's working capital needs and creditworthiness. Working capital is the difference between a company's current assets (e.g., cash, accounts receivable, inventory) and its current liabilities (e.g., accounts payable, short-term debt), representing the funds available to meet short-term obligations.
Here are some key points regarding working capital limits:
Assessment of Working Capital Needs
Before approving working capital limits, financial institutions assess a company's working capital requirements. This involves analyzing the company's current assets, current liabilities, and historical cash flow patterns. The goal is to determine how much short-term financing the company needs to support its operations.
Types of Working Capital Limits
Cash Credit (CC) Limit: This is a revolving credit facility that allows a company to borrow funds up to a specified limit as needed. Interest is charged only on the amount borrowed.
Overdraft (OD) Limit: An overdraft limit allows a company to withdraw more money from its bank account than it actually has. Interest is charged on the overdrawn amount.
Letter of Credit (LC) Limit: This limit is provided for issuing letters of credit, which can be used in international trade to guarantee payment to suppliers.
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Bank Guarantee (BG) Limit: A bank guarantee limit allows a company to provide guarantees to third parties, such as suppliers or government authorities, on behalf of the company.
Creditworthiness Assessment: Financial institutions evaluate a company's creditworthiness before granting working capital limits. Factors considered include the company's financial statements, credit history, collateral, business plan, and overall financial health.
Security or Collateral: In some cases, banks may require the company to provide security or collateral to secure the working capital limits. This collateral can be in the form of assets like inventory, receivables, or property.
Repayment Terms: The terms of repayment for working capital limits vary. Companies may need to repay the borrowed funds within a specified period, or they may have revolving credit lines where they can continuously borrow and repay as needed.
Review and Renewal: Working capital limits are not necessarily permanent. Financial institutions may periodically review and renew the limits based on the company's performance, financial stability, and creditworthiness.
Purpose of Funds: The funds obtained through working capital limits are typically used for various short-term purposes, such as purchasing inventory, covering payroll, paying suppliers, or managing seasonal fluctuations in cash flow.
Interest Rates: The interest rates on working capital limits can vary depending on the type of facility, the creditworthiness of the company, and prevailing market conditions.
It's important for businesses to manage their working capital effectively to ensure they have sufficient liquidity to meet their short-term obligations. Having access to working capital limits can be essential for smooth operations and seizing business opportunities. However, businesses should also be cautious about overleveraging themselves and should use these limits wisely to support their growth and profitability.
