In the present day context the sources of finance for working capital may be categorised as:
(1) Trade credit.
(2) Bank credit.
(3) Current provisions of non-bank short-term borrowings.
(4) Long-term services comprising equity capital and long-term borrowings.
However; in India the primary sources of financing the working capital are trade credit, and short-term bank credit, stated to have financed more than ¾ th requirements of working of Indian industry.
Two other short-term sources of working capital finance are:
(i) Factoring of receivables.
(ii) Commercial papers.
Meaning of Trade Credit:
It refers to the credit extended by the supplier of goods and services in the normal course of transaction/business/sale of the firm. According to trade practices cash is not paid immediately for purchases but after an agreed period of time. Thus deferred of payment i.e., trade credit represents a service of finance for credit purchases.
There is however no formal/specific negotiation for trade credit. It is an informal arrangement between the buyer and the seller. There are no legal instruments/acknowledgements of debt which are granted on an open account basis. Such credit appears in the records of the buyer of goods as sundry creditors/accounts payable.
A variant of accounts payable is bills/notes payable. Unlike the open account nature of accounts payable, bills/notes payable represent documentary evidence of credit purchases and a formal acknowledgement of obligation to pay for credit purchases on a specified (maturity) date failing which legal/panel action for recovery will follow.
A notable feature of bills/notes payable is that they can be rediscounted and the seller does not necessary have to hold it till maturity to receive payment. However, it creates a legally enforceable obligation on the buyer of goods to pay on maturity whereas the accounts payable have more flexible payment obligations. Although most of the trade credit is on an open account as accounts payable, the suppliers of goods do not extend credit indiscriminately. Their decisions as well as the quantum is based on the consideration of factors such as earnings record over a period of time, liquidity position of the firm and post record of payments.
Trade credit, as a source of short terms/working capital finance, has certain advantages. It is easily, almost automatically, available. Moreover, it is a flexible and spontaneous source of finance. The availability and magnitude of trade credit is related to the size of operations of the firm in terms of sales/purchases.
The requirement of credit purchases to support the existing sales is Rs. 5 lakhs/day. If the purchases are made on the credit of 30 days. The average outstanding accounts payable/ trade credit (finance) will amount to Rs. 1.5 crores (30 days × 5 lakhs).
The increase in purchases of goods to support higher sales level to Rs. 6 lakhs will imply a trade credit finance of (30 days × 6 lakhs) = 1.8 crores.
If the credit purchases of goods decline, the availability of trade credit will correspondingly decline.
- Trade credit is also an informal, spontaneous service of finance.
- Does not require negotiation and formal agreement.
- Trade credit is free from the restrictions associated with formal/negotiated service of finance/credit.
Trade credit does not involve any explicit interest charge. However, there is an implicit cost of trade credit. It depends on the credit terms offered by the supplier of goods.
Suppose, the terms of credit are, 45 days net, the payable amount to the supplier of goods is the same whether paid on the date of purchase or on the 45th day means trade credit has no cost or it is cost free.
But, if the credit terms are 2/15, net 45 means there is discount for prompt payment, the trade credit beyond the discount period has a cost which is equal to –
= [(Discount/1 – Discount)] × 360 days/credit period – discount period)]
Then, explicit interest rate/cost,
= [(0.02/1 – 0.02) × (360/45 – 15)]
= [(0.02/0.98) × (360 – 30)]
= [(0.0204) × (6)]
= 0.024 or 24%
Alternatively, the credit terms, 2/15 net 45, imply that the firm i.e., buyer is entitled to 2% discount for payment made within 15 days when the entire payment is to be made within 45 days. Since the net amount is due in 45 days, failure to take the discount means paying an extra 2% for using the money for an additional 30 days. If a firm were to pay 2% for every 30 days period over a year, there will be 12 such periods because 360/30 = 12. This amounts to an annual interest rate/cost of 24%.
If the terms of credit are 2/10, net 30 the cost of credit works out to 36.4%.
The smaller the difference between the payment day and the end of the discount period, the larger is the annual interest/cost of trade credit.
- The cost of trade credit is generally very high beyond the discount period. Firms should avail of the discount on prompt payment. If however, they are unable to avail of discount, the payment of trade credit should be delayed till the last day of credit (net, period and beyond without impairing their credit-worthiness.
- A precondition for obtaining trade credit particularly by a new company is cultivating good relationship with suppliers of goods and obtaining their confidence by honouring commitments.
Bank credit is the primary institutional source of working capital finance in India. In fact, it represents the most important source for financing of current assets.
Working capital is provided by banks in the following ways:
- Cash credits/overdrafts (limit)
- Purchase/discount bills
- Working capital term loans
- Letter and Credit (LC)
1.Cash Credit/Overdrafts (Limit):
Under cash credit/overdraft form/arrangement of bank finance, the bank specifies a predetermined borrowing/credit limit. The borrower can draw/ borrow up to the stipulated credit/over draft limit. Within the specified limit, any number of drawls/drawings is possible to the extent of his requirements periodically. Similarly, repayments can be made whenever desired during the period.
The interest is determined on the basis of running balance/amount actually utilized by the borrower and not on the sanctioned limit. However, a minimum i.e., commitment charge may be payable on the un-utilised balance irrespective of the level of borrowing for availing of the facility.
This form of bank financing of working capital is highly attractive to the borrowers because:
(i) It is flexible in that although borrowed funds are repayable on demand, banks usually do not recall cash advances/roll them over.
(ii) Borrower has the freedom to draw the amount in advance as and when required while the interest liability is only on the amount actually outstanding.
However, cash credit/overdraft is inconvenient to the banks and hampers credit planning. It was the most popular method of bank financing of working capital in India till the early 90s.
With the emergence of new banking since the mid 90’s, cash credit cannot at present exceed 20% of the maximum permissible bank finance (MPBF)/credit limit to any borrower.
Under this arrangement, the entire amount of borrowing is credited to the current account of the borrower or released in cash.
The borrower has to pay interest on the total amount. The loans are repayable on demand or in periodic installments. They can also be renewed from time to time.
As a form of financing, loans imply a financial discipline on the part of borrowers.
From a modest beginning in the early 90’s, at least 80% of MPBF/credit limit must now be in the form of loans in India.
- Bill Purchased/Discounted:
This arrangement is of relatively recent origin in India. With the introduction of the New Bill Market Scheme in 1970 by RBI, bank credit is being made available through discounting of usance bills by banks.
The RBI envisaged the progressive used of bills as an instrument of credit as against the prevailing practice of using the widely-prevalent cash credit arrangement for financing working capital. The cash credit arrangement gave rise to unhealthy practices. As the availability of bank credit was unrelated to production needs, borrowers enjoyed facilities in excess of their legitimate needs. Moreover, it led to double financing.
This was possible because credit was taken from different agencies for financing the same activity. This was done, for example, by buying goods on credit from suppliers and raising cash credit by hypothecating the same goods. The bill financing is intended to link credit with the sale and purchase of goods and thus, eliminate the scope of misuse or diversion of credit to other purposes.
The amount made available under this arrangement is covered by the cash credit and overdraft limit. Before discounting the bill, the bank satisfies itself about the credit-worthiness of the drawer and the genuineness of the bill. To popularise the scheme the discount rates are fixed at lower rates than those of cash credit, the difference being about 1 – 1.5%.
The discounting banker asks the drawer of the bill i.e., seller of goods to have his bill accepted by the drawee (buyers) bank before discounting it. The later grants acceptance against the cash credit limit, earlier fixed by it on the basis of borrowing value of stocks. Therefore, the buyer who buys goods on credit cannot use the same goods as a source of obtaining additional bank credit.
The modus operandi of bill finance as a source of working capital financing is that a bill arises out of a trade sale-purchase transaction on credit. The seller of goods draws the bill on the purchaser of goods, payable on demand or after a usage period not exceeding 90 days.
On acceptance of the bill by the purchaser, the seller offers it to the bank for discount/purchase. On discounting the bill, the bank releases the funds to the seller. The bill is presented by the bank to the purchaser/acceptor of the bill on due date for payment. The bills can also be rediscounted with the other bank/RBI. However, this form of financing is not very popular in the country.
- Term Loan for Working Capital:
Under this arrangement bank advance loans for 3-7 years repayable in yearly or half-yearly instalments.
In compliance of RBI directions, banks presently grant only a small part of the fund based working capital facilities to a borrower by the way of running cash credit account, a major portion is in the form of working capital demand loan.
This arrangement is presently applicable to borrowers having working capital facilities of Rs.10 crores and above. The minimum period of WCDL which is basically non-operable account keep on changing. The WCDL is granted for a fixed term on carrying of which it has to be liquidated renewed or rolled over.
- Letter of Credit (LC):
While the other forms of bank credit are direct forms of financing in which banks provide funds as well bear risk, letter of credit is an indirect form of working capital financing and banks assume only the risk. The credit being provided by the supplier himself.
The purchaser of goods on credit obtains a letter of credit from a bank. The bank undertakes the responsibility to make payment to the supplier, in case the buyer fails to meet his obligations.
Thus the modus operandi of letter of credit is that the supplier sells goods on credit/extents credit/finance to the purchaser, the bank gives a guarantee and bears risk only in case of default by the purchaser.
Mode of Security:
Banks provide credit on the basis of following modes of security:
In this mode of security, the banks provide credit to borrowers against the security of movable property, usually inventory of goods. The goods hypothecated, however, continue to be in the possession of the owner of these goods, i.e., borrower.
The rights of the lending bank (hypothecate) depend upon the terms of the contract between the borrower and the lender. Although the bank does not have physical possession of the goods, it has the legal right to sell the goods to realise the outstanding loan. Hypothecation facility is normally not available to new borrower.
It is a different mode of security from hypothecation, unlike in the latter; the goods which are offered as security are transferred to the physical possession of the lender.
An essential perquisite of pledge, therefore, is that the goods are in the custody of the bank. The borrower who offers the security is called a ‘Pawnon’ or pledger while the bank is called ‘Pawnee’ or pledgee.
The lodging of the goods by the pledger to the pledgee is a kind of bailment. Therefore, pledge creates some liabilities for the bank. It must take reasonable care of goods pledged with it. The term reasonable care means care which a prudent person would like to protect his property. He would be responsible for any loss or damage if he uses the pledged goods for his own purposes. In case of non-payment of bank loans the bank enjoys the right to sell the goods.
The term lien refers to the right of a party to retain goods belonging to another party until a debt due to him is paid.
Lien can be of following two types:
(i) Particular lien
(ii) General lien
Particular lien is a right to retain goods until a claim pertaining to these goods is fully paid. General lien is applied till all dues of the claimant are paid.
Bank usually enjoy general lien.
It is the transfer of a legal/equitable interest in specific immovable property for securing the payment of debt. The person who parts with the interest in the property is called mortgagor and the bank in whose favour the transfer takes place is the mortgagee. The instrument of transfer is called the mortgage deed.
Mortgage is thus, conveyance of interest in mortgaged property. The mortgage interest in the property is terminated as soon as the debt is paid. Mortgages are taken as an additional security for working capital credit by banks.
Where immovable property of one person is by the act of parties or by the operation of law, made security for the payment of money to another and the transaction does not amount to mortgage, the latter person is said to have a charge on the property and all the provisions of simple mortgage will apply to such a charge.
The provisions are as follows:
(i) A charge is not the transfer of interest in the property through it is security for payment. But mortgage is a transfer of interest in the property.
(ii) A charge may be created by the act of parties or by the operation of law. But a mortgage can be created only the act of parties.
(iii) A charge need not be made in writing but a deed must be attested.
(iv) Generally, a charge cannot be enforced against the transferee for consideration without notice. In a mortgage, the transferee of the mortgaged property can acquire the remaining interest in the property, if any is left.
Regulation of Bank Finance:
Traditionally bank credit has been an easily assessable source of meeting the working capital needs of business firms. Indian banks have not been concerning themselves about the soundness or otherwise of the business carried out or about the actual end use of the loan. In other words they have been extending credit to industry and trade on the basis of security. This resulted in a number for distortions in financing of working capital by banks.
Consequently, bank credit has been subjected to various rules, regulations and controls. The RBI had appointed various committees to ensure equitable distribution of bank resources to various sectors of economy. These committees suggest ways and means to make the bank credit an effective instrument of industrialization.
The two concepts of working capital are net working capital and gross working capital. Net working capital is a qualitative concept; the management will also get an idea about the ease and cost of raising working capital. Net working capital is measured by the current ratio viz. current assets/current liabilities.
Normally the current ratio should be 2:1. A larger ratio indicates greater solvency and vice versa. Of course, excessive current ratio would point out poor financial planning and it would reduce income.
The concept of gross capital is a financial concept whereas that of net concept is an accounting concept. For the management more interest is in the amount of current assets with which it has to operate. “However, in an ever changing economy it is very difficult to secure perfect equilibrium between inflow and outflow of cash”.
So, enough supply of working capital is the objective of sound financial management. While aiming at sound working capital management, certain factors must always be kept in mind.
(a) Nature of business,
(b) Size of business,
(c) Terms of purchase and sale,
(d) Turnover of inventories,
(e) Process of manufacture,
(f) Importance of labour,
(g) Proportion of raw material to total costs,
(h) Cash requirements,
(i) Seasonal variations,
(j) Banking connections,
(k) Growth and expansion.
In gross sense working capital means the total of current assets and in net sense it is the difference between current assets and current liabilities.
Through working capital management, the finance manager tries to manage the current assets, current liabilities and to evaluate the interrelationship that exists between them, i.e. it involves the relationship between a firm’s short-term assets and short-term liabilities.
The aim of working capital management is to deploy such amount of current assets and current liabilities so as to maximize short-term liquidity. The management of working capital involves managing inventories, accounts receivable and payable as also cash.
The two steps involved in the working capital management are as follows:
(i) Forecasting the amount of working capital; and
(ii) Determining the sources of working capital.
Apart from the two mentioned above the following two additional important aspects should be kept in mind while managing working capital:
(a) Inclusion of Profit:
There is a lot of controversy regarding inclusion of profit in working capital requirement forecast. There are two views. The first view suggests that profit should be included in the working capital. The second view suggests that it should not be included. Inclusion or exclusion of profit depends primarily on the managerial policy adopted by the firm.
From the first view, if working capital is calculated on the basis of actual cash outflow then profit should not be included in calculating working capital because financing of profit is not required.
From the second view, where balance sheet approach is adopted for calculating working capital, profit element is not ignored as this should be included in the amount of debtors.
(b) Exclusion of Depreciation:
Depreciation does not involve any actual cash outflow, so it should not be included in the estimation of working capital.