Working Capital Management using OD and CC Loans – All Aspects and Key Considerations

Working capital management is one of the most sensitive business operations. It simply means having sufficient funds to facilitate the organization’s operation, be it through salaries paid to employees, purchasing raw materials and inventory or other costs incurred in the operation of the business. Maintaining adequate liquidity can often prove challenging for companies, such as tiny- to medium-sized enterprises, especially when cash flows are inconsistent.

When the firm faces a cash-flow shortage in the short term, OD loans and CC loans are drawn upon to overcome the temporary gap. These forms of short-term financing can be classified as auxiliary funding sources to bridge liquidity gaps. Still, as with any financial tool, it has merits and demerits. This blog shall provide a balanced view of using OD and CC loans as working capital management tools to assist in deciding when and how to use such solutions wisely.

What Are OD and CC Loans? A Quick Overview

Let’s first understand what Overdraft (OD) and Cash Credit (CC) loans are, as they often overlap but have different uses.

What Are Overdraft (OD) Loans?

An overdraft is a short-term credit facility the bank makes to the business. The business can withdraw more money from its current account than is available when meeting its short-term needs up to a specified limit. Interest is charged only on the amount used, not the limit itself. Such flexibility proves handy during short-term liquidity needs for clearing obligations to suppliers, paying employees, or any unanticipated expense.

Cash Credit (CC) Loans

A cash credit is an extension of a revolving credit facility the banks offer to any business. CC loans differ from OD loans in that, unlike OD, the credit line permitted under CC loans allows enterprises to access such credit lines to be re-borrowed once repaid. Businesses can draw funds, as and when needed, to a specified limit and pay interest only on the amount borrowed. Hence, it offers flexibility for companies with varying working capital needs.

OD and CC loans are applied for short-term capital to sponsor daily operations in a business.

Why Use OD and CC Loans in Working Capital Management?

If  OD and CC loans are correctly used, the cash flow will be healthy, and the business will run. Explore the benefits:

Flexibility in Managing Cash Flow

One of the most essential benefits of OD and CC loans is flexibility.  A company can gain access to cash anytime needed through these financing options. This would alleviate managing cash flow with irregularities that may prove unexpected. Whether you pay salaries, buy any inventory, or deal with urgent costs, OD and CC loans keep operations running on schedule without waiting for delayed client payments.

Fast and Easy Availability of Liquidity

OD and CC loans provide instant access to cash. This can be crucial when your business has unforeseen costs or opportunities that require immediate funding. The credit facilities are significantly quicker than conventional loans, which usually take lengthy approvals to become operational. Liquidity instantly becomes available to businesses to take advantage of scarce time windows or fulfil immediate financial obligations.

Lower Interest Rates Compared to Long-Term Loans

The interest rates for OD and CC loans are relatively lower than other forms of credit, such as long-term loans or credit cards. This is because these loans are relatively short-term, either collateralized on property or inventory.

For businesses which require cash only for short periods, OD and CC can be more economical than other forms of borrowing.

Revolving Credit Facilities

Both OD and CC loans constitute a revolving credit facility;  businesses can borrow, repay, and borrow again as may be required. This cyclical access to funds will give businesses an assured source of capital to meet the recurring working capital needs without the labour of reapplied loan requests.

Develops Credit History

Proper use of OD and CC loans, for example, through repayment of balances at the right time, improves the credit score attached to the business entity. This, therefore, enhances the possibility of accessing larger loans or more attractive funding in the long term. A better credit history is one of the most effective tools for supporting the growth of your business in the long term.

Limitations of Using OD and CC Loans in Working Capital Management

Though OD and CC loans are flexible and convenient, risk may also be associated with them. Businesses should be aware of the disbenefit of excessive reliance on such credit facilities.

The Risk of Overborrowing

OD and CC loans have the ease of money access, but sometimes, business organizations tend to borrow more than required. It is revolving credit line-based and will always attract businesses to lend beyond their current needs. Overborrowing can lead to higher debt levels, and without a sound repayment program, most of them would face difficulty cutting the web of obligations.

High Interest on Outstanding Balances

While the rates on OD and CC loans are typically lower than long-term loans, interest is accrued quickly on outstanding balances. Interest charges can be expensive if the business fails to fully pay the borrowed amount within the agreed repayment period.

The Loan Has a Short-Term Nature

OD and CC loans are short-term borrowings to meet a company’s short liquidity needs. However, such loans cannot finance long-term capital outlays or investments. Using these loans for extended periods poses financial risk as long-term ineligibility may constrain a company’s ability to meet the reputation obligations if the cash flows persist.

Collateral and Security Risks

Both OD and CC loans tend to require collateral.  A company may offer real estate or inventory as collateral or receivables. When a business fails to repay, there is a great danger of losing some valuable assets. Such can be very risky for small companies or even startups since losing some collateral severely hurts operations.

Risk of Financial Instability

Relying on OD and CC loans for working capital finance may cause a firm to face long-term financial instability. OD and CC loans are short-term loans, and over-relying on them without adjusting the root cash flow problem compounds financial trouble rather than solving it.

Efficient Use of OD and CC Loans in Working Capital Management

Hence, with OD and CC loans, careful planning would save your business from the pitfalls associated with such loans. Here are some tips on managing working capital effectively using OD and CC loans.

Careful Planning of Repayments ensure that your business has a proper repayment plan so as not to fall prey to these pitfalls of overborrowing and high-interest charges.

Use for Short-term ONLY: Use OD and CC loans to bridge short-term cash gaps only but not long-term capital requirements.

Monitor your borrowings and expenses: monitor the borrowing levels periodically only to borrow as much as required to maintain liquidity and not for unproductive expenditure.

Diversify Financing Options for OD and CC loans should not be the only sources of funds because they have critical deficiencies in stability and can be too risky when used in isolation to meet capital requirements.

As such, OD and CC loans can be valuable tools that help a firm manage its working capital when the cash flow is inadequate for business operations.  Businesses, however, must be very attentive to these risks and not be too dependent on these credit facilities. This, therefore, means using it responsibly as part of a more holistic financial plan and realizing effective management of cash flows to protect long-term economic health.

Blog crafted by Ghowthami, Content Developer,
Rankyouhigher, Coimbatore.