Overview
Working capital for a business is one of the critical factors to ensure seamless business operations. It is recognized as a valuable financial tool that offers a reasonable measure for the short-term financial position of a business. While making a decision regarding lending funds to business lenders also consider margin money requirements for the business. But, what does it mean?
Working capital margins could be understood as the additional amount to be retained by a business over and above the working capital of a business for meeting uncertain expenses. Such a buffer or margin value maintained by a business is a certain percentage of sales, which demonstrates its ability to meet its short-term obligations amidst fluctuations in cash inflows.
In some cases, margin money against working capital also indicates a portion of working capital required to be committed by the borrower business to the lender while applying for a working capital loan. Such margin is a certain percentage of the total working capital which acts an upfront payment to secure loan showing the borrower’s assurance to repay debt within certain period. For example, where the borrower is seeking a working capital loan for Rs. 20L with a 20% margin money requirement, then the margin money would be Rs.4L.
In terms of lending, lenders consider margin money against working capital as the income generated from extending working capital loan to the borrower business.
Margin Money against Working Capital- How to calculate?
Margin money against working capital could be defined as a certain percentage of the total working capital loan negotiated as per the financial soundness of the borrower and lender’s lending policies among other factors.
Margin Money against working capital = Total Working Capital Required X Margin %
Margin percentage- It denotes the portion of working capital which the borrower needs to contribute on their own as an upfront payment.
Working Capital Calculation- Working capital is calculated by eliminating all short term liabilities from current assets.
For instance, where the total working capital requirement is Rs. 1 Cr with a margin requirement of 10%, then the borrower business will need at least Rs. 10L from their own funds.
Margin Money for Working Capital – Calculation, and Benefits
Margin money against working capital- Need and Importance
Display of Commitment by the Borrower-
Margin money against working capital is typically a risk mitigation measure applied by lenders which allows the borrowers to demonstrate their commitment for repayment while making the business loan application.
Sharing risks between the parties-
Borrowers depositing an upfront amount for the working capital loan indicates mutual risk sharing between the parties.
Access to large funds-
A higher percentage of margin money requirement might mean access to higher working capital loans for a business.
Variability-
The margin requirements might be different for each applicant from small to larger percentage for larger sums such as purchase of real estate or heavy machinery, etc. Margins may also vary depending upon the loan size, credit history, business financials, credit policies, etc. among others.
Acts as a Collateral-
Margin money acts as a collateral allowing borrower businesses to leverage their investments facilitating business growth.
Indicates repayment ability of a business-
A working capital margin is vital for businesses to demonstrate their abilities to repay loans, establish their financial soundness, and seamless business operations. A healthy margin ensures smooth operations, allowing businesses to meet financial obligations and seize growth opportunities.
Factors affecting margin money against working capital
Business Size-
Typically, larger businesses have a higher margin requirement on the basis of their higher working capital needs and higher risk potential.
Creditworthiness-
Businesses with a strong credit history may have lower margin requirements relatively as compared to those with lower credit ratings.
Financial Statements-
Financial documents (Profit & Loss account and Balance Sheet) with stronger sales and profits records might need more working capital as compared to those with lower sales. Lenders use such documents to measure the repayment ability of the borrower business.
Nature of the business
Certain businesses might need higher margins due to the nature of their end product. For instance, while manufacturing businesses may need higher margins owing to longer production durations and inventory requirements, service-based businesses may require lower margins due to lesser inventory requirements.
Lender Policies
The lending terms and policies of the lender might also affect the margin requirements against working capital. For instance, lenient credit policies offering extended tenure for repayment might lead to higher outstanding receivables with higher margin requirements. Similarly, the risk mitigation policies for every lender might differ on the basis of the financial soundness of the borrower and market conditions.
Economic Conditions –
The margin requirements against working capital are also affected by the economic factors. For instance, lenders might seek a higher margin during periods of economic instabilities and vice-versa.
Inventory Management
Efficient Inventory management techniques adopted by an enterprise might lower down the margin requirements for the business and vice-versa. For example, just in time inventory management can significantly reduce the working capital requirements for a business.
Sales and Business growth
Rise in the sales volume with faster expansion of the business might put pressure on the cash flows of the business prompting higher working capital to sustain growing demands.
Why is margin money against working capital different for different businesses and how?
The margin money against working capital requirement is different for different businesses due to the following factors-
Type and Size of the Business
Working capital and margin requirements are different for each business on the basis of their size, operational volume and nature of business. For instance, where trading businesses need large amounts of working capital (means lesser margin money) with large quantities of goods as stocks whereas working capital needs for manufacturing are way lesser.
Business Cycle
The working capital and margin requirements also differ for every business on the basis of their business cycle. For instance, businesses with seasonal business cycles might have higher working capital requirement and thus lesser margin money during the same and vice-versa. Furthermore, businesses also need working capital to meet their higher sales demands by either seeking funds from investors or borrowing funds.
Production Cycle
Production cycle or operation cycle could be defined as the time needed to manufacture the end product from raw materials. Since every product has a different production cycle it has a significant influence on its working capital. Accordingly, businesses with longer production cycles have larger working capital needs thus leaving little margin funds. In other words, the need for working capital has close correlation with its expanded production cycle.
Operational Efficiency
The operational efficiency of a business is affected by various factors such as shorter manufacturing cycles, faster sales, and quick debt recollection periods. Such operational efficiency is again achieved through effective management of the working capital. Businesses with higher operational efficiency need lower working capital investments. Similarly, businesses with lower operational efficiency need more working capital funds for managing their operations.
Benefits of Working Capital Margin for businesses
Ensures liquidity and stability-
Margin money against working capital ensures availability of emergency funds for emergencies such as payment of salaries, supplier invoices, and meeting other operational requirements. It also prevents any unwarranted disruptions in the operational cycle while helping to maintain a steady financial business position.
Increasing operational efficiency-
Margin money helps businesses to enhance their operational efficiency through multiple ways including optimization of inventory levels, effective management of account receivables, and saving time on conversion of inventory into liquidity.
Growth Potential for the Business-
Businesses holding a strong working capital position have a better ability to invest in new prospects, seize growth opportunities or extend their business operations without having to resort to external sources for funding immediately.
Improved creditworthiness-
Businesses with strong working capital margins indicate its better financial position facilitating better negotiation for lending terms and faster loan approvals. This helps businesses get better internal credit scores when ranked by the lending institutions.
Crisis Management –
Margin money against working capital allows businesses to sustain financial disruptions and prevent instances of business insolvency during recessions or unforeseen circumstances.
Business Credibility-
Businesses with a strong financial position demonstrates its financial stability and reliability to its suppliers, partners, customers and investors.
Allows the power to negotiate terms-
A stable financial position due to availability of margin money allows the businesses to leverage better terms with suppliers increasing chances of favorable terms and discounts.
Conclusion
Therefore, margin money against working capital is a crucial factor contributing to the growth and prosperity of a business. Business owners and entrepreneurs should strive to develop a grasp on the concept to leverage margin funds for achieving optimum business growth and finding the right balance between working capital and the margin money. A healthy working capital margin could be vital for its survival but too many funds tied up as margin might lead to losing investments or profit-making opportunities for the business.
Moreover, businesses should keep a track on their working capital KPIs to quickly identify and work on areas for improvement and make necessary modifications for cash flow optimization. We, at BankKeeping are experts who can deal with all your banking needs from monitoring timely renewal of loans to preparing necessary documentation for loan management.