Drawing power is crucial for businesses looking to manage credit and ensure steady cash flow. The dp calculation determines how much a business can borrow, based on its financial standing. Accurate calculations help avoid over-borrowing or underutilizing credit limits.
In this article, we’ll walk you through the steps of calculating drawing power for better financial planning, enabling your business to make informed decisions on borrowing and cash flow management.
What is Drawing Power?
Drawing power refers to the amount of credit a business can access from a financial institution. It’s determined by the business’s current assets, liabilities, and the loan-to-value (LTV) ratio set by the lender.
Essentially, drawing power helps businesses understand their available credit limit, enabling them to maintain smooth operations, manage cash flow, and avoid over-leveraging.
It plays a vital role in securing short-term loans or overdrafts, ensuring businesses can access the funds they need without facing financial strain.
Step 1: Identify Your Current Assets
The first step in calculating drawing power is to identify your current assets. These are assets that can be easily converted into cash within one year, such as:
- Accounts Receivable: Money owed by customers for goods or services delivered.
- Inventory: The value of goods or raw materials you hold for resale or production.
- Cash and Bank Balances: Available funds in your business accounts.
Accurately valuing your assets is essential because overestimating or undervaluing them can skew your drawing power. The more accurate your asset values, the more precise your drawing power calculation will be.
Step 2: Assess Your Current Liabilities
The next step is to evaluate your current liabilities. These are short-term debts or obligations that must be settled within a year, such as:
- Accounts Payable: Amounts owed to suppliers for goods or services received.
- Short-Term Loans: Loans due within the next 12 months.
- Overdrafts: Amounts drawn from a bank that need to be repaid quickly.
Subtracting current liabilities from your current assets helps you understand the true available credit for your business. This step ensures that you don’t overestimate your borrowing capacity and helps you avoid taking on too much debt.
Step 3: Apply the Loan-to-Value (LTV) Ratio
The Loan-to-Value (LTV) ratio is set by the lender and represents the percentage of your current assets that can be used to secure the loan. It’s essential to apply this ratio to ensure the lender’s risk is minimized.
For example, if the LTV ratio is 70%, and your current assets total ₹10,00,000, the maximum drawing power you can access is ₹7,00,000.
To apply the LTV ratio, simply multiply your available assets (after subtracting liabilities) by the LTV percentage.
Example:
If your current assets total ₹10,00,000 and your liabilities amount to ₹4,00,000, your available assets are ₹6,00,000. If the LTV ratio is 70%, your drawing power would be:
Drawing Power = ₹6,00,000 × 70% = ₹4,20,000
This step ensures that you’re not borrowing beyond what the lender is willing to back with your assets.
Step 4: Calculate Your Drawing Power
Now that you have your current assets, current liabilities, and the LTV ratio, you can calculate your drawing power. The formula is simple:
Drawing Power = (Current Assets – Current Liabilities) × LTV Ratio
Using the figures from previous steps, let’s go through an example:
- Current Assets: ₹10,00,000
- Current Liabilities: ₹4,00,000
- LTV Ratio: 70%
Calculation:
Drawing Power = (₹10,00,000 – ₹4,00,000) × 70%
Drawing Power = ₹6,00,000 × 70% = ₹4,20,000
So, your available drawing power is ₹4,20,000.
This figure represents the maximum amount of credit your business can access based on your financial health. It helps you plan your borrowing without over-stretching your resources.
Step 5: Use a Drawing Power Calculator
While manually calculating drawing power is helpful, using an online drawing power calculator can save time and ensure accuracy. These tools take into account your financial details and instantly provide your available credit limit based on current assets, liabilities, and the LTV ratio.
By calculating drawing power for better financial planning, businesses can make more informed decisions about borrowing. A drawing power calculator removes the guesswork, helping you avoid errors and streamline the process.
Common Mistakes to Avoid in DP Calculation
- Overestimating Assets: Avoid counting slow-moving stock or non-liquid assets in your drawing power.
- Ignoring Liabilities: Don’t leave out short-term debts like accounts payable or overdrafts.
- Using Outdated Data: Always use the most recent financial records to ensure accuracy.
- Misunderstanding LTV Ratio: Apply the correct LTV ratio from your lender to avoid miscalculations.
Conclusion
Accurate drawing power calculations are crucial for effective financial planning and growth. By understanding your current assets, liabilities, and the LTV ratio, you can make informed decisions on borrowing and cash flow management.
Regularly calculating drawing power for better financial planning ensures that your business can access the right amount of credit without over-leveraging. Using tools like a drawing power calculator makes this process quicker and more accurate, empowering you to manage your finances more effectively.