Diagnosing your borrowing need: working capital, term loan or non-fund limit, and why the purpose decides the product

Most MSME owners walk into a bank saying "I need ₹50 lakh" without saying what the money will do. The banker then fits you into whatever product is easiest to sanction, and you end up paying for a machine out of your cash credit limit or funding a slow-paying customer with a five-year loan. Getting the purpose right before you apply is the single cheapest way to get a better loan, a smoother sanction and a repayment schedule your cash flow can actually carry.

What you need to know

The golden rule: match the tenure of the money to the life of the use. Money that comes back to you within one operating cycle (raw material, stock, credit given to customers) should be funded by short-term, revolving credit. Money locked into something that pays back over years (a machine, a shed, a vehicle, a new outlet fit-out) should be funded by a term loan with an instalment schedule. When you break this rule you create a mismatch: short-term money funding a long-term asset squeezes your daily liquidity, and long-term money funding stock makes you pay interest on cash you do not need all year.

The three families of MSME credit.

• Fund-based working capital — cash credit (CC), overdraft (OD), working capital demand loan, bill or invoice discounting, packing credit for exporters. Money actually leaves the bank. You pay interest only on what you use, but the limit is tied to your stock and receivables.
• Term loans — machinery loans, vehicle loans, loans against property, working capital term loans. A fixed amount is disbursed for a specific purpose and repaid in instalments (EMIs or structured instalments) over years.
• Non-fund-based limits — bank guarantees (BG) and letters of credit (LC). No money leaves the bank on day one; the bank takes a contingent risk on your behalf. You pay a commission and usually keep a cash margin, and the limit becomes a loan only if something goes wrong.

Why lenders care about purpose. Credit officers are trained to look for "diversion of funds", meaning money sanctioned for one purpose and used for another. Using a CC limit to buy a machine, paying personal expenses from a term loan, or routing a loan to a sister concern are red flags that can lead to recall of the loan. A clean, documented purpose also decides the security the lender takes: stock and debtors are hypothecated for working capital, the machine itself is hypothecated for a machinery loan, and property is mortgaged for a loan against property.

Separate the need into buckets before you add them up. A single "requirement" is usually three or four different needs:

1. Capital expenditure (capex): asset cost including GST (check whether you can claim input tax credit), installation, freight and any civil work.
2. Incremental working capital: the extra stock and receivables your higher sales will create, minus the extra credit your suppliers will give you.
3. Non-fund needs: tender earnest money, performance guarantees, advance payment guarantees, inland or import LCs for suppliers who want payment security.
4. Promoter margin: the share of each bucket you must bring from your own funds. Banks almost never fund the whole of a need. A common rule of thumb is 15–25% margin on capex and 20–25% on working capital, but the exact margin is set by each lender's policy.

How to size incremental working capital. Convert your operating cycle into days and multiply by daily amounts:

• Raw material stock = days of stock × (annual raw material cost ÷ 365)
• Work-in-progress and finished goods = days held × (annual cost of production ÷ 365)
• Receivables = credit days × (annual sales ÷ 365)
• Less: supplier credit = days of credit × (annual purchases ÷ 365)

The result is the net working capital the new business locks up. That figure, minus your margin, is the limit you should ask for.

The "do I need a loan at all?" test. Before borrowing, check whether faster collections, a supplier credit extension, clearing dead stock or selling an idle asset closes part of the gap. Borrowing to fund slow collections from customers who pay late is often the most expensive way to solve a collections problem.

This lesson is education, not lending or financial advice; lender margins, product names and policies vary, so confirm the details with your banker and your CA before applying.

Step-by-step method

1. Write one sentence for each thing the money will do, in plain words ("buy a second CNC turning centre", "carry 60 days of receivables on the new OEM order").
2. Tag each sentence as capex, working capital or non-fund.
3. For capex, collect quotations and add freight, installation and GST; note whether GST input credit is available so you know the net cost.
4. For working capital, list your current operating-cycle days for stock, work-in-progress, finished goods, receivables and supplier credit, from your books, not from memory.
5. Apply the days to the incremental sales you expect and compute the net working capital locked up.
6. List every guarantee or LC the new business will require: who wants it, for how much, for how long.
7. Apply an assumed promoter margin to each bucket and total your own contribution. Check it against cash you actually have.
8. Run the "do I need a loan at all?" test on each bucket and reduce what you can.
9. Write the final ask as separate lines: term loan ₹, working capital enhancement ₹, BG/LC limit ₹, own contribution ₹.

Common mistakes

• Asking for one round number instead of separate facilities, which lets the lender pick the easiest product rather than the right one.
• Paying for machinery or a shed out of the CC limit and then finding the account overdrawn against drawing power in peak season.
• Forgetting that more sales means more receivables: many owners fund the machine but not the 60 days of credit the new customer demands.
• Ignoring non-fund needs until the tender deadline, then scrambling for a guarantee backed by a full-value FD margin.
• Assuming the bank will fund the full cost and discovering the promoter margin only at sanction.
• Borrowing to cover late payers without first tightening credit terms and follow-up.

Ask the AI Business Tutor

• "I run a [type of business] in [city] with annual turnover of about ₹[amount]. I plan to [describe the expansion or need]. My operating cycle is [stock days], [receivable days] and [supplier credit days]. Help me split my requirement into term loan, working capital and non-fund limits, calculate the incremental working capital, and list the questions my banker is likely to ask about each part."