WORKING CAPITAL FINANCING

OUTLINE Accruals Trade credit Working capital advance by commercial banks Regulation of bank finance Public deposits

Inter-corporate deposits
Short-term loans from financial institutions Rights debentures for working capital Commercial paper Factoring

ACCRUALS The major accrual items are wages and provisions.

Accruals vary with the level of activity of the firm.

While accruals are a welcome source of financing, they are typically not amenable to control by management.

TRADE CREDIT

Trade credit represents the credit extended by the suppliers of goods and services. It is a spontaneous source of finance.
The confidence of suppliers is the key to securing trade credit.

The cost of trade credit is:

Discount % 360

x
100 Discount % Credit period Discount period

WORKING CAPITAL ADVANCE BY COMMERCIAL BANKS Application and processing Sanction, terms and conditions Forms of bank finance Cash credits/Overdrafts Loans Purchase/Discount of Bills Letter of credit Security Hypothecation Pledge Margin amount

MAXIMUM PERMISSIBLE

BANK FINANCE (MPBF)

Tandon Committee had suggested three methods for determining the MPBF Method 1 : MPBF = 0.75 (CA CL) Method 2 : MPBF = 0.75 (CA) CL

Method 3 : MPBF = 0.75 (CA CCA) CL

CA = current assets

CL = non-banking current liabilities

CCA = core current assets

PUBLIC DEPOSITS These are unsecured deposits from the public.

Public deposits cannot exceed 25 percent of share capital

and free reserves.

The maximum maturity period allowed for public

deposits is 3 years. However, for NBFCs it is 5 years.

INTER-CORPORATE DEPOSITS A deposit made by one company with another, normally for a period up to six months is referred to as an inter-

corporate deposit.
Inter-corporate deposits are typically unsecured. Inter-corporate deposits are usually of three types: call deposits, three-month deposits, and six-month deposits.

SHORT-TERM LOANS

FROM FINANCIAL INSTITUTIONS

Insurance companies provide short-term loans to manufacturing companies with an excellent track record. Such loans are unsecured and given for a period of 1 year, renewable for two consecutive years. A company, to be eligible for such loans, should satisfy certain conditions relating to dividend payment, debtequity ratio, current ratio, and interest cover ratio.

RIGHTS DEBENTURES

FOR WORKING CAPITAL

A company can issue rights debentures to its shareholders

to augment the long-term source for working capital

requirements The key guidelines applicable to rights debentures relate to the quantum of such issues and the debt : equity ratio

COMMERCIAL PAPER Commercial paper represents short-term unsecured promissory notes issued by firms which enjoy a fairly

high credit rating.

Commercial paper is either directly placed with investors or sold through dealers The effective pre-tax cost of commercial paper is:

Face value Net amount realised

Net amount realised

360
Maturity period

FACTORING
A factor is a financial institution which offers services relating to management and financing of debt arising from credit sales.
CLIENT (SELLER)

1 Places order 3 Delivers goods and invoice with notice to pay the factor 8 Pays balance amount

CUSTOMER (BUYER)

4 Sends invoice copy

6 Follows up

2 Fixes customer limit

5 Prepays up to 80%
FACTOR

7 Pays

SUMMING UP Typically, the current assets of the firm are supported by a combination of long-term and short-term sources of

financing.
The following sources of finance more or less exclusively

support current assets: accruals, trade credit, working

capital advance by commercial banks, public deposits, inter-corporate deposits, shot-term loans from financial institutions, rights debentures for working capital, commercial paper, and factoring.