Mastering the calculation of drawing power is essential for businesses to effectively manage their working capital. Understanding how much credit you can access allows you to make informed financial decisions and optimize cash flow.
In this guide, we’ll walk you through the steps of calculating drawing power and highlight its significance in securing funding and maintaining financial flexibility for growth.
What is Drawing Power?
Drawing power (DP) is the limit within which a borrower can access funds under their cash credit limit. It represents the maximum amount a business can withdraw from the working capital limit sanctioned by banks or financial institutions.
DP is a crucial aspect of the Cash Credit (CC) facility, as it directly impacts a business’s ability to manage liquidity. Banks regularly update the drawing power based on the business’s current assets and liabilities.
Why is Drawing Power Calculation Important?
- Optimize Cash Flow: Accurate calculation ensures businesses can manage daily expenses without liquidity issues.
- Secure the Right Funding: Lenders use drawing power to assess creditworthiness and determine the funding a business can access.
- Informed Decision-Making: Knowing available credit helps businesses make confident financial decisions.
- Monitor Credit Utilization: Regular updates prevent exceeding the working capital limit and ensure smooth operations.
The Key Components of Drawing Power Calculation
To calculate drawing power accurately, businesses must consider several key components:
- Current Assets: This includes receivables, inventory, and other short-term assets that can be converted into cash.
- Current Liabilities: Short-term debts and obligations that reduce the available capital for withdrawal.
- Margin: A portion of current assets set aside as a buffer, usually determined by the bank or lender, which cannot be used for drawing power.
The formula for drawing power is:
Drawing Power = (Current Assets – Current Liabilities) – Margin
How to Calculate Drawing Power for Your Business
Calculating drawing power involves a simple process. Here’s a step-by-step guide:
- Determine Current Assets: Add up all your short-term assets, such as receivables, inventory, and cash equivalents. For example, if you have ₹50 lakh in receivables, ₹30 lakh in inventory, and ₹10 lakh in cash equivalents, your total current assets will be ₹90 lakh.
- Subtract Current Liabilities: Identify your short-term liabilities, such as unpaid bills, short-term loans, and trade payables. If these total ₹40 lakh, subtract this amount from your current assets.
- Apply the Margin: The margin is the percentage of current assets that is reserved and cannot be used. For instance, if the margin is 20%, calculate 20% of ₹90 lakh, which equals ₹18 lakh. This amount is subtracted from the available drawing power.
- Calculate Drawing Power: Using the formula:
Drawing Power = (Current Assets – Current Liabilities) – Margin
In this case:
Drawing Power = (₹90 lakh – ₹40 lakh) – ₹18 lakh = ₹32 lakh
This means your drawing power is ₹32 lakh, the amount of credit you can access.
Common Mistakes to Avoid in Drawing Power Calculation
- Miscalculating Current Assets: Only liquid assets count. Ensure you’re including receivables, inventory, and cash equivalents, not long-term assets.
- Ignoring Liabilities: Include all short-term debts and obligations to avoid overestimating available capital.
- Underestimating the Margin: The margin is crucial, ensure it’s correctly factored in to avoid inflated drawing power.
- Not Updating Regularly: Regularly recalculate drawing power to reflect changes in assets, liabilities, and margins.
How Calculating Drawing Power Can Benefit Your Business
- Improved Cash Flow Management: Knowing your drawing power ensures you can access necessary funds when needed, optimizing cash flow for daily operations.
- Better Financing Decisions: With a clear understanding of available credit, businesses can make smarter decisions when seeking loans or other financial products.
- Increased Creditworthiness: Regularly calculating drawing power and maintaining a healthy ratio boosts your credibility with lenders, improving your chances of securing favorable terms.
- Strategic Planning: Accurate drawing power calculations allow businesses to plan for growth, investments, and other major financial moves with confidence.
Conclusion
Accurate drawing power calculation is vital for managing working capital and accessing necessary funding. It ensures you know how much credit you can utilize, helping with cash flow management, loan decisions, and financial planning.
Regularly updating this calculation allows businesses to maintain liquidity and make strategic growth decisions without the risk of overextending their credit.
If you’re looking for flexible financing solutions, platforms like Recur Club offer structured debt solutions to help high-growth companies and SMEs scale.