Unit - 5 Working Capital Financing

NOIDA INSTITUTE OF ENGINEERING & TECHNOLOGY
GREATER NOIDA
Course & Branch : MBA

Subject Name: Working Capital Management
Code: AMBAFM0412
Unit – 5
Financing of Working Capital
By
Dr. Riyazuddin
Designation
Assistant Professor
School of Management
NIET, GREATER NOIDA
Working Capital Financing
Working capital financing is used to fund your company’s investment in short-term assets
such as accounts receivable and inventory, and to provide liquidity so that your company can
fund its day-to-day operations including payroll, overhead and other expenses.
. Subject: by: Slide no. #

Working Capital Financing
 Working Capital Finance Working Capital is a financial metric which
represents operating liquidity available to a business.
 The goal of working capital management is to ensure that the firm is able to
continue its operations and that it has sufficient cash flow to satisfy both
maturing short-term debt and upcoming operational expenses.

Objectives of Working Capital Financing
• Maintaining the required fund balance of the organization.
• Effectively managing various sources of financing.
• Concerned towards lowering the cost of financing.
• Effective utilization of financed funds.
• Timely availability of credit.
• Continuous monitoring and controlling of finances.

Advantages of working capital financing
• Can be relatively low cost financing, especially if secured, short-term debt.
• Non-dilutive or minimally-dilutive to equity holders.
• Amount available to borrowing, grows as the business grows.
• Smoothens out fluctuations, in cash flow due to seasonality or a large, slow-pay customer.

Disadvantages of working capital financing
• Can be expensive, especially accounts receivable factoring and merchant cash advances.
• Not for pre-revenue companies. Funding is usually based on accounts receivable,

inventory, or reliable future revenue.
• Lender or finance company requirements. Borrower may need to modify its credit,
billing and collection practices to conform.
• Restrictive covenants. Working capital loans require various financial and operational
covenants by the borrower.

Sources of Working Capital Finance
Working Capital Revolver
Accounts Receivable Factoring
Invoice Discounting
Purchase Order Financing
Trade Finance
Customer Advances
Vendor Credit
Merchant Cash Advances
MRR Line of Credit

Summary
• Working capital financing is used to fund your company’s investment in short-term assets
such as accounts receivable and inventory, and to provide liquidity so that your company
can fund its day-to-day operations including payroll, overhead and other expenses.
• Working capital smoothens out fluctuations, in cash flow due to seasonality or a large, slow-
pay customer.

Quiz
1. Discus the working capital financing.

2. How cost of the working capital can be kept low?
3. Discuss the vendor credit.
4. How effective utilization of funds can be insured.
5. Discuss the need of working capital financing.
6. Discuss the objectives of working capital financing.
7. What are the advantages of working capital financing?
8. Discuss the disadvantages of working capital financing

Cost Benefit Analysis
• a process that helps you determine the economic benefit of a decision, so you can decide
whether it's worth pursuing.
• A cost-benefit analysis is the process of comparing the projected or estimated costs and
benefits (or opportunities) associated with a project decision to determine whether it makes
sense from a business perspective.

Cost Benefit Analysis: Application
• To evaluate whether a capital investment is worth it.

• To decide whether to hire new employees.
• To determine whether a project or operating change is feasible.
• To develop a benchmark for comparing projects.
• To weigh up one marketing initiative against another.
• To appraise the desirability of a proposed policy.
• To prioritize investments, so you're focusing on the actions that return the most value first.

Cost Benefit Analysis: Framework
• To evaluate whether a capital investment is worth it.

To decide whether to hire new employees.
• To determine whether a project or operating change is feasible.
• To develop a benchmark for comparing projects.
• To weigh up one marketing initiative against another.
• To appraise the desirability of a proposed policy.
• To prioritize investments, so you're focusing on the actions that return the most
value first.

1. Establish a Framework for Analysis
• Identify the goals and objectives you’re trying to address with the proposal. What do you
need to accomplish to consider the endeavor a success?
• Decide what metric you’ll be using to measure and compare the benefits and costs. To
accurately compare the two, both your costs and benefits should be measured in the same
“common currency.”

2. Identify Your Costs and Benefits
Benefits can be:

• Direct: For example, increased revenue and sales generated from a new product
• Indirect: Such as increased customer interest in your business or brand
• Intangible: For example, improved employee morale
• Competitive: For example, being a first-mover within an industry or vertical

3. Assign a Rupee Value to Each Cost and Benefit
• Direct costs and benefits will be the easiest to assign a rupee amount to.
Indirect and intangible costs and benefits, on the other hand, can be
challenging to quantify.
• That does not mean you shouldn’t try, though; there are many software options
and methodologies available for assigning these less-than-obvious values.

4. Tally the Total Value of Benefits and Costs
• If total benefits outnumber total costs, then there is a business case for you to proceed with
the project or decision. If total costs outnumber total benefits, then you may want to
reconsider the proposal.
• If the costs outweigh the benefits, ask yourself if there are alternatives to the proposal you
haven’t considered.

Cost Benefit Analysis: Accrued Wages & Taxes
• Accrued wages refers to the amount of liability remaining at the end of a reporting period
for wages that have been earned by hourly employees but not yet paid to them.
• This liability is included in the current liabilities section of the balance sheet of a business.
• Accrued wages are recorded in order to recognize the entire wage expense that a business
has incurred during a reporting period, not just the amount actually paid.

Cost Benefit Analysis: Accounts Payable
• The accounts payable process or function is immensely important since it involves nearly all
of a company's payments outside of payroll.
• The accounts payable process might be carried out by an accounts payable department in a
large corporation, by a small staff in a medium-sized company, or by a bookkeeper or
perhaps the owner in a small business

Cost Benefit Analysis: Accounts Payable
To safeguard a company's cash and other assets, the accounts payable process should have
internal controls. A few reasons for internal controls are to:
• prevent paying a fraudulent invoice.

• prevent paying an inaccurate invoice
• prevent paying a vendor invoice twice
• be certain that all vendor invoices are accounted for

Cost Benefit Analysis: Bank Loan
• Working capital loans are as good as term loan for a short period. These loans
may be repaid in installments or a lump sum at the end.
• The borrower should take such loans for financing permanent working capital
needs. The cost of interest would not allow using such loans for temporary
working capital.

Cost Benefit Analysis: Overdrafts
• Cash credit or bank overdraft is the most useful and appropriate type of
working capital financing extensively used by all small and big businesses.
• It is a facility offered by commercial banks whereby the borrower is sanctioned

a particular amount which can be utilized for making his business payments.

Cost Benefit Analysis: Overdrafts
• The borrower has to make sure that he does not cross the sanctioned limit.
• The best part is that the interest is charged to the extent the money is used and not on the
sanctioned amount which motivates him to keep depositing the amount as soon as possible
to save on interest cost.

Difference between Cash Credit and Overdraft
Cash Credit Overdraft

It is normally given on security of stock, debtors etc. It is normally given on security of a fixed asset.
The maximum amount is calculated as a percentage of sale The maximum amount allowed is calculated mainly on basis
and stock along with financial statements. of financial statements and security.
For e.g. A bank allowed cash credit unto 80% of stock plus
20% of sales.
It should be used for the purpose of business. Can be used for any purpose
Balance Sheet, P & L account , VAT reports is required be Financial statements are generally not required to be
submitted to bank generally annually or quarterly. resubmitted after approval.
Cash Credit Overdraft

Cost Benefit Analysis: Bill Discounting
• Invoice discounting can be technically defined as the selling of bill to invoice
discounting company before the due date of payment at a value which is less
than the invoice amount.
• The difference between the bill amount and the amount paid is the fee of the
invoice discounting to the company. The fee will depend on the period left
before payment date, amount and the perceived risk.

Cost Benefit Analysis: Bill Discounting
• The bills or invoices under bill discounting are legally the 'bill of exchange'. A
bill of exchange is a negotiable instrument which is negotiable mere by
endorsing the name.
• In the case of bill discounting, such bills can be either payable to the bearer or
payable to order. Therefore, after discounting a bill, a bank can further get the
bill discounted from other banks in case of cash flow requirement.

Cost Benefit Analysis: Commercial Paper
• Commercial paper is an unsecured, short-term debt instrument issued by a
corporation, typically for the financing of accounts receivable, inventories and
meeting short-term liabilities. .
• Commercial paper is usually issued at a discount from face value and reflects
prevailing market interest rates. Commercial paper is an unsecured and
discounted promissory note issued to finance the short-term credit needs of
large institutional buyers.

Cost Benefit Analysis: Certificate of Deposit
• Certificate of Deposit (CD) implies an unsecured, money market negotiable

instrument, issued by the commercial bank or financial institution, at a
discount to face value at market rates, against the amount deposited by an
individual, for a stipulated time.
• In finer terms, certificate of deposit is a fixed interest bearing term deposit,

which has a fixed maturity. It limits the access to the funds, until the lock-in
period of the investment, i.e. the depositor cannot withdraw funds, on demand.

Cost Benefit Analysis: Factoring
• Factoring is an arrangement whereby a business sells all or selected accounts
payables to a third party at a price lower than the realizable value of those
accounts.
• The third party here is known as the 'factor' who provides factoring services to
business.
• The factor would not only provide financing by purchasing the accounts but
also collects the amount from the debtors.

Cost Benefit Analysis: Factoring
• Factoring is of two types with recourse and without recourse.
• The credit risk of nonpayment by the debtor is borne by the business in case of
with recourse and it is borne by the factor in the case of without recourse.

Cost Benefit Analysis: Secured Term Loans
• Secured term loan is a loan granted to the business where the borrower then pledges some
form of security or collateral against the loan.
• Lenders look at either property (commercial or residential) or a debtors book as security

against a loan.
•
• Secured loans are normally short medium term loans ranging from 6 months to 5 years.

Summary
• Cost-benefit analysis is the process of comparing the projected or estimated

costs and benefits (or opportunities) associated with a project decision to
determine whether it makes sense from a business perspective.
• Trade credit is a short-term credit extended by suppliers of goods and services

in the normal course of business, to a buyer in order to enhance sales.

Quiz
1. Define the cost benefit analysis.
2. Discuss the application of cost benefit analysis.
3. What is meant by recourse and non recourse factoring?
4. Explain the fee paid in bill discounting process.
5. Explain the secured term loans.
6. Describe the commercial paper.
7. Discuss the trade credit.
8. Describe the accounts payable.

Recap
• Cost-benefit analysis is the process of comparing the projected or estimated costs and
benefits (or opportunities) associated with a project decision to determine whether it makes
sense from a business perspective.
• Trade credit is a short-term credit extended by suppliers of goods and services in the normal
course of business, to a buyer in order to enhance sales.

Financing of working capital is to be arranged considering the practical aspect, i.e. whether it
is fixed working capital or variable working capital:
Sources of funds:
Long Term Sources
Short Term Sources

Long Term Sources:
Restored to finance permanent working capital
It is believed that this type of working capital will be needed constantly

Long Term Sources:
Owned Sources Borrowed Sources
• Issue of Shares • Debentures

• Retained Earnings • Long Term Loans
• Reserves
• Sale of Fixed Assets
• Retiring CL below Book
Value

Long Term Sources- Owned
Issue of Shares:
1. Equity & Preference
2. No burden on the earnings
Retained Earnings:
1. Part of earned profit
2. Regular & Costless source

Equity Share Capital
Ordinary Share Capital
• Authorized Capital
• Issued Capital
• Subscribed Capital
• Paid up Capital
Dividends are non tax deductible for company

Shareholders expect more returns

Reserves:
1. Do not involve fixed charges
2. Use is considered Proper & Profitable
Sale of Fixed Assets:

1. Being obsolete or scrap
2. Faulty planning causes surplus of assets
3. Fully irregular & non-dependable source

 Retiring Current Liabilities below Book Value:
1. Availing discount against early payment of Current Liabilities.
2. Non-recurring nature

Long Term Sources- Borrowed
Debentures:
1. Issue like shares
2. Consist fixed burden (Coupon)
3. Should be considered after stability of business earnings
Long Term Debts:

Financial Corporations, Investment Co.

Short Term Sources of Funds
Indigenous Bankers
Trade Credit
Installment Credit
Advances
Accounts Receivable Credit
Accrued Expenses
Deferred Incomes
Commercial Paper

Indigenous Bankers:
• Private money-lenders and other country bankers used to be the only source of finance prior
to the establishment of commercial banks.
• They used to charge very high rates of interest and exploited the customers to the largest
extent possible.
• Now-a-days with the development of commercial banks they have lost their monopoly.

Trade Credit:
• Trade credit refers to the credit extended by the suppliers of goods in the normal course of
business.
• As present day commerce is built upon credit, the trade credit arrangement of a firm with its
suppliers is an important source of short-term finance.

Installment Credit:
• This is another method by which the assets are purchased and the possession of goods is
taken immediately but the payment is made in installments over a pre-determined period of
time.
• Generally, interest is charged on the unpaid price or it may be adjusted in the price.
• But, in any case, it provides funds for some time and is used as a source of short-term
working capital by many business houses which have difficult fund position.

Advances:
• Some business houses get advances from their customers and agents against orders and this
source is a short-term source of finance for them.
• It is a cheap source of finance and in order to minimize their investment in working capital,
some firms having long production cycle, specially the firms manufacturing industrial
products prefer to take advances from their customers.

Factoring or Accounts Receivable Credit:
• Raising short-term finance is through accounts receivable credit offered by commercial

banks and factors.
• A commercial bank may provide finance by discounting the bills or invoices of its
customers.
• Thus, a firm gets immediate payment for sales made on credit.

Accrued Expenses:
• Accrued expenses are the expenses which have been incurred but not yet due and hence not
yet paid also.
• These simply represent a liability that a firm has to pay for the services already received by
it.
• The most important items of accruals are wages and salaries, interest, and taxes.

Deferred Incomes:
• Deferred incomes are incomes received in advance before supplying goods or services.
• They represent funds received by a firm for which it has to supply goods or services in
future.
• These funds increase the liquidity of a firm and constitute an important source of short-term
finance.

Commercial Paper:
• Commercial paper represents unsecured promissory notes issued by firms to raise short-
term funds.
• It is an important money market instrument in advanced countries like U.S.A. In India, the
Reserve Bank of India introduced commercial paper in the Indian money market on the
recommendations of the Working Group on Money Market (Vaghul Committee).

Commercial Paper:
• Commercial paper represents unsecured promissory notes issued by firms to raise short-
term funds.
• It is an important money market instrument in advanced countries like U.S.A. In India, the
Reserve Bank of India introduced commercial paper in the Indian money market on the
recommendations of the Working Group on Money Market (Vaghul Committee).

Regulation of Bank Credit
Financial Stability
Economic Management
Consumer Protection
Supporting Specific Sectors

Regulation of Bank Credit
Methods of Bank Credit Regulation:
Reserve Requirements
Capital Requirements
Lending Limits
Interest Rate Controls
Qualitative Supervision

Working Capital Control: Banks
Previously working capital finance provided by the banks to trade and industry was
regulated by the Reserve Bank of India through a series of guidelines / instructions issued.
There were various quantitative and qualitative restrictions on bank’s lending.
The banks were also expected to ensure conformity with the basic financial disciplines
prescribed by the RBI from time to time under Credit Authorization Scheme (CAS).

Working Capital Requirements Up to Rs 1 Crore
The assessment of working capital requirement of borrowers, other than SSI units, requiring
fund based working capital limits up-to Rs.1.00 crore and SSI units requiring fund based
working capital limits up-to Rs.5.00 crore from the banking system may be made on the
basis of their projected annual turnover.

The assessment of working capital requirement of borrowers, other than SSI units, requiring
fund based working capital limits up-to Rs.1.00 crore and SSI units requiring fund based
working capital limits up-to Rs.5.00 crore from the banking system may be made on the
basis of their projected annual turnover.
In accordance with guidelines, the working capital requirement is to be assessed at 25% of
the projected turnover to be shared between the borrower and the bank, viz. borrower
contributing 5% of the turnover as net working capital (NWC) and bank providing finance
at a minimum of 20% of the turnover.

Banks may evolve an appropriate system for assessing the working capital credit needs of
borrowers whose requirement are above Rs.1 crore.
Banks may adopt any of the under-noted methods for arriving at the working capital
requirement of such borrowers.
The turnover method, as prevalent for small borrowers may be used as a tool of assessment
for this segment as well.
Since major corporates have adopted cash budgeting as a tool of funds management, banks
may follow cash budget system for assessing the working capital finance in respect of large
borrowers.

The banks may, at their discretion, carry out the assessment based on projected turnover
basis or the traditional method.
If the credit requirement based on traditional production / processing cycle is higher than
the one assessed on projected turnover basis, the same may be sanctioned, as borrower must
be financed upto the extent of minimum 20 per cent of their projected annual turnover.

Norms for Inventory/Receivables
In order to provide flexibility in the assessment of credit requirements of borrowers based
on a total study of borrowers' business operations, i.e., taking into account the production /
processing cycle of the industry as well as the financial and other relevant parameters of the
borrower.
The banks have also been permitted to decide the levels of holding of each item of
inventory as also of receivables, which in their view would represent a reasonable build-up
of current assets for being supported by bank finance.

Grant of Ad hoc Limits
To meet the contingencies, banks may decide on the quantum and period for granting ad hoc
limits to the borrowers based on their commercial judgment and merits of individual cases.
While granting the ad hoc limits the banks must ensure that the aggregate credit limits
(inclusive of ad hoc limits) do not exceed the prescribed exposure ceiling.

Bills Discipline
In respect of borrowers enjoying fund-based working capital credit limits of Rs. 5 crore and
more from the banking system, the banks are required to ensure that the book-debt finance
does not exceed 75 per cent of the limits sanctioned to borrowers for financing inland credit
sales.
The remaining 25 per cent of the credit sales may be financed through bills to ensure greater
use of bills for financing sales.

Loan Component and Cash Credit Component
Banks may change the composition of working capital by increasing the cash credit
component beyond 20 per cent or increase the loan component beyond 80 per cent, as the
case may be, if they so desire.
Banks are expected to appropriately price each of the two components of working capital
finance, taking into account the impact of such decisions on their cash and liquidity
management.

Committees on WC Financing
Dahejia Committee, 1969
Tandon Committee, 1975
Chore Committee, 1980

Dahejia Committee, 1969
Dahejia Committee, 1969:
 Chairman: Shri V T Dahejia

 Constituted by: National Credit Council
 year: 1968
 Report Submission: September 1969

Dahejia Committee, 1969-Findings
Industries generally availed short term credit from banks in excess to the amount based on
their growth in production
Utilization of short tem bank credit for raising non current assets.
Bankers did not try to evaluate total financial position of the borrower through cash flow
analysis

Dahejia Committee, 1969-Recommendations
Appraisal of the credit application should be made in reference to total financial position, as
shown by cash flow analysis.
Cash credit of borrowers should be divided in two parts

Hard Core - Minimum level of inventory
Short Term – Increase in these
A customer should confine its dealing with one bank only to eliminate double or multiple
financing.

Tandon Committee, 1975
 Chairman: Shri P L Tondon

Constituted by: Reserve Bank of India
year: July, 1974
Report Submission: 9th August, 1975

Tandon Committee, 1975
Borrowers decide as how much to borrow.
Bank credit considered as first source of loan.
Bank credit has been granted on the basis of security available rather than level of operation
borrower’s business.
It is a wrong concept that only security can protect credit.

Tandon Committee, 1975 Recommendations
Borrower has to maintain proper financial discipline.
Banker as lender to maintain borrower’s current assets at an acceptable level-

• Reasonable level of CA & based on standard
• Certain CA should be raised by long term sources
Banker should have knowledge about end use of bank credit just to ensure that it is for the
purpose for which it was sanctioned

Tandon Committee: Fixation of Norms
First Method
Second Method
Third Method

First Method
Borrower will finance 25% of WC by long term sources.
Bank will finance at the most of 75% of WC
Minimum Current Ratio 1.17 : 1
Bank Borrowing = 0.75 (CA - CL)

Second Method
At least 25% of Current Assets should be arranged by long term sources & the gap will be
provided by the bank
Minimum Current Ratio 1.33 : 1
Bank Borrowing = {(0.75 CA) - CL)}

Third Method
Borrower has to arrange finance through long term sources for all Core Current Assets
(CCA) and 25% of the balance Current Assets.
Bank Borrowing = {0.75 (CA- CCA) – CL}

Chore Committee, 1980
 Chairman: Shri K B Chore

 Constituted by: Reserve Bank of India
Review was specially to be made with reference to the gap between sanctioned credit &
extent of their utilization.

Chore Committee, 1980 Recommendations
Continuance of existing system.

Cash credit, Loans, Bills etc
No bifurcation of cash credit accounts.

i.e. Loan & demand cash credit
Separate rate limits for peak level & non peak level requirements.

Reduction in over dependence on bank credit.
No frequent sanction of temporary limits.
Submission of quarterly statements.
All borrowers having WC limit of Rs 50 lac or more (Earlier limit was Rs 1 crore)

Reduction in over dependence on bank credit.
No frequent sanction of temporary limits.
Submission of quarterly statements.
All borrowers having WC limit of Rs 50 lac or more (Earlier limit was Rs 1 crore)

Weekly Assignment
1. Define sources of funds in brief.
2. Explain the long-term sources of funds.
3. Describe the various tools for short term funds.
4. Throw the light on the Tondon Committee.
5. Throw the light on the Chore Committee.

MCQs
1. Concentration banking
a) increases idle balances.
b) moves excess funds from a concentration bank to regional banks.
c) is less important during periods of rising interest rates.
d) improves control over corporate cash.
2.Which of the following marketable securities is the obligation of a commercial bank?

e) Commercial paper .
f) Negotiable certificate of deposit
g) Repurchase agreement
h) T-bills

MCQs
3.Marketable securities are primarily
a) short-term debt instruments.
b) short-term equity securities.
c) long-term debt instruments.
d) long-term equity securities.
4. Time consumed in clearing a check through the banking system.
e) Processing float
f) Deposit float
g) Collection float
h) Availability float
5. Commercial paper is essentially
i) another term for a junk bond.
j) a short-term unsecured corporate IOU.
k) an intermediate-term corporate bond.
l) a certificate that may be exchanged for a share of common stock at a specified future date.
Old Question Papers
Link for old question papers:

https://www.niet.co.in/examination.php

Expected Questions for University Exam
Define the cash budget method of working capital?
What is marketable security?.
What are the motives for maintaining liquidity in the form of marketable securities?
Discuss briefly the various types of marketable securities. .
‘Why do investors prefer marketable securities? .

Unit - 5 Working Capital Financing

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NOIDA INSTITUTE OF ENGINEERING & TECHNOLOGY

Course & Branch : MBA

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• Non-dilutive or minimally-dilutive to equity holders.

• Amount available to borrowing, grows as the business grows.

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• Not for pre-revenue companies. Funding is usually based on accounts receivable,

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1. Discus the working capital financing.

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• To evaluate whether a capital investment is worth it.

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• To evaluate whether a capital investment is worth it.

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Benefits can be:

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• prevent paying a fraudulent invoice.

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• It is a facility offered by commercial banks whereby the borrower is sanctioned

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Cash Credit Overdraft

Cash Credit Overdraft

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• Certificate of Deposit (CD) implies an unsecured, money market negotiable

• In finer terms, certificate of deposit is a fixed interest bearing term deposit,

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• Lenders look at either property (commercial or residential) or a debtors book as security

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• Cost-benefit analysis is the process of comparing the projected or estimated

• Trade credit is a short-term credit extended by suppliers of goods and services

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Restored to finance permanent working capital

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Owned Sources Borrowed Sources

• Issue of Shares • Debentures

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Dividends are non tax deductible for company

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Sale of Fixed Assets:

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1. Availing discount against early payment of Current Liabilities.

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