Working capital financing

Working capital financing

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  Working capital financing Subject:Financial management Submitted by: Vidhu Arora Roll no. : 68-MBA-16 Submitted to: Dr Sameer Gupta
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  Introduction The term workingcapital is commonly used for the capital required for day-to-day working in a business concern, such as for purchasing raw material, for meeting day-to-day expenditure on salaries, wages, rents rates, advertising etc. Working capital refers to the circulating capital required to meet the day to day operations of a business firm. Working capital may be defined by various authors as follows: 1. According to Weston & Brigham - “Working capital refers to a firm’s investment in short term assets, such as cash amounts receivables, inventories etc. 2. Working capital means current assets. —Mead,Baker and Malott 3. “The sum of the current assets is the working capital of the business” —J.S.Mill The term “working capital” is often referred to “circulating capital” which is frequently used to denote those assets which are changed with relative speed from one form to another i.e., starting from cash, changing to raw materials, converting into work-in-progress and finished products, sale of finished products and ending with realization of cash from debtors. Working capital has been described as the “life blood of any business which is apt because it constitutes a cyclically flowing stream through the business”. Concepts of working capital: 1. Gross Working Capital:It refers to the firm’s investment in total current or circulating assets. 2. Net Working Capital:The term “Net Working Capital” has been defined in two different ways: a.] It is the excess of current assets over current liabilities. This is, as a matter of fact, the most commonly accepted definition. Some people define it as only the difference between current assets and current liabilities. The former seems to be a better definition as compared to the latter. b.]It is that portion of a firm’s current assets which is financed by long-term funds. 3. Permanent Working Capital: This refers to that minimum amount of investment in all current assets which is required at all times to carry out minimum level of business activities. In other words, it represents the current assets required on a continuing basis over the entire year. Tandon Committee has referred to this type of working capital as “Core current assets”. 4. Temporary Working Capital: The amount of such working capital keeps on fluctuating from time to time on the basis of business activities. In other words, it represents additional current assets required at different times during the operating year. For example, extra inventory has to be maintained to support sales during peak sales period. Similarly, receivable also increase and must be financed during period of high sales. On the other hand investment in inventories, receivables, etc., will decrease in periods of depression. Suppliers of temporary working capital can expect its return during off season when it is not required by the firm. Hence, temporary working capital is generally financed from short term sources of finance such as bank credit. 5. Negative Working Capital: This situation occurs when the current liabilities exceed the current assets. It is an indication of crisis to the firm. Importance or Advantages of Adequate Working Capital Working capital is the life blood and nerve centre of a business. Just as circulation of blood is essential in the human body for maintaining life, working capital is very essential to maintain the smooth running of a business. No business can run successfully without an adequate amount of working capital. The main advantages of maintaining adequate amount of working capital are as follows: 1. Solvency of the business: Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production. 2. Goodwill: Sufficient working capital enables a business concern to make prompt payments and hence helps in creating and maintaining goodwill.
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  3. Easy loans:A concern having adequate working capital, high solvency and good credit standing can arrange loans from banks and other on easy and favorable terms. 4. Cash Discounts: Adequate working capital also enables a concern to avail cash discounts on the purchases and hence it reduces costs. 5. Regular supply of raw materials: Sufficient working capital ensures regular supply of raw materials and continuous production. 6. Regular payment of salaries, wages and other day-to-day commitments: A company which has ample working capital can make regular payment of salaries, wages and other day-to-day commitments which raises the morale of its employees, increases their efficiency, reduces wastages and costs and enhances production and profits. 7. Exploitation of favourable market conditions: Only concerns with adequate working capital can exploit favourable market conditions such as purchasing its requirements in bulk when the prices are lower and by holding its inventories for higher prices. 8. Ability to face Crisis: Adequate working capital enables a concern to face business crisis in emergencies such as depression because during such periods, generally, there is much pressure on working capital. 9. Quick and Regular return on Investments: Every Investor wants a quick and regular return on his investments. Sufficiency of working capital enables a concern to pay quick and regular dividends to its investors as there may not be much pressure to plough back profits. This gains the confidence of its investors and creates a favourable market to raise additional funds i.e., the future. 10. High morale: Adequacy of working capital creates an environment of security, confidence, high morale and creates overall efficiency in a business. Excess or Inadequate Working Capital Every business concern should have adequate working capital to run its business operations. It should have either redundant or excess working capital nor inadequate or shortage of working capital. Both excess as well as short working capital positions are bad for any business. However, out of the two, it is the inadequacy of working capital which is more dangerous from the point of view of the firm. Disadvantages ofRedundant or Excessive Working Capital  Excessive Working Capital means ideal funds which earn no profits for the business and hence  the business cannot earn a proper rate of return on its investments.  When there is a redundant working capital, it may lead to unnecessary purchasing and  accumulation of inventories causing more chances of theft, waste and losses.  Excessive working capital implies excessive debtors and defective credit policy which may cause higher incidence of bad debts.  It may result into overall inefficiency in the organization.  When there is excessive working capital, relations with banks and other financial institutions may not be maintained.  Due to low rate of return on investments, the value of shares may also fall.  The redundant working capital gives rise to speculative transactions. Disadvantages or Dangers ofInadequate Working Capital  A concern which has inadequate working capital cannot pay its short-term liabilities in time. Thus, it will lose its reputation and shall not be able to get good credit facilities.  It cannot buy its requirements in bulk and cannot avail of discounts, etc.  It becomes difficult for the firm to exploit favorable market conditions and undertake profitable projects due to lack of working capital.  The firm cannot pay day-to-day expenses of its operations and its creates inefficiencies, increases costs and reduces the profits of the business.  It becomes impossible to utilize efficiently the fixed assets due to non-availability of liquid funds.  The rate of return on investments also falls with the shortage of working capital.
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  Financing of WorkingCapital A) Financing of permanent/fixed/or Long term working capital: Permanent working capital should be financed in such a manner that the enterprise may have its uninterrupted use for a sufficient long period. There are five important sources of long term or permanent capital:  Shares: The most important source for the permanent or long-term Working Capital is the issue of equity, preference and deferred shares.  Debentures: Another important source for raising the permanent Working Capital is the issue of debentures, which means a debt where the debenture holder is considered as the creditor of the company.  Retained Earnings: Otherwise called ploughing back of profits. It means the reinvestment by the company’s surplus earnings in its business.  Loans from Financial Institutions: Financial institutions such as Commercial banks, Life Insurance Corporation of India, Industrial Finance Corporation of India, State Finance Corporation, Industrial Development Bank of India, etc.,also provide term loans for Working Capital needs.  Public Deposits (Fixed): These deposits are fixed in nature and are accepted by a business enterprise directly from the public. B) Financing of Temporary, variable or short term working capital: The main sources of short term working capital are as follows  Indigenous Bankers: Private money lenders used to be the only source of finance prior to the establishment of commercial banks. They used to charge very high rates of interest.  Trade credit: Trade credit refers to the credit extended by suppliers of goods in the normal course of business. The credit worthiness of a firm and the confidence of its suppliers are the main basis of securing trade credit. The main advantages of trade credit are: • It is easy and convenient method of finance. • It is flexible as the credit increases with the growth of firm Financing of Working Capital Financing of Temporary, variable or short term working capital Financing of permanent/fixed/or Long term working capital
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  • It isinformal and spontaneous source of finance.  Installment credit: In this assets are purchased and possession of goods is taken immediately but payment is made in installment over a predetermined period. Generally, interest is charged on the unpaid price or it may be adjusted in the price.  Advances: Some business houses get advances from their customers and agents against orders. Usually the manufacturing concerns having long production cycle prefer to take advances from their customers.  Factoring or Accounts Receivable Credit: A commercial bank may provide finance by discounting bills or invoices of its customers. Thus, a firm gets immediate payment for sale made on credit. A factor is a financial institution which offers services related to management and financing of debts arising out of credit sales.  Accrued income represents a liability a firm has to pay for the services it has already received. The major accrual items are wages/salaries, taxes and interests. These are simply what the firm owes to its employees and to the government. Accrued wages amd salaries represents obligations payable by the firm to its employees. Accrued taxes and interest constitutes other source of financing like taxes and interest  Deferred Incomes: Deferred incomes are incomes received in advance before supplying goods or services. However, firms having great demand for its products and services, and those having good reputation in the market can demand deferred incomes.  Commercial Paper: Commercial paper represents unsecured promissory notes issued by firms to raise short-term funds. But only large companies enjoying high credit rating and sound financial health can issue commercial paper to raise short-term funds. The Reserve Bank of India has laid down a number of conditions to determine eligibility of a company for the issue of commercial paper. Only a company which is listed on the. Stock exchange has a net worth of at least Rs. 10 corers and a maximum permissible bank inance of Rs. 25 crores can issue commercial paper not exceeding 30 per cent of its working capital limit. The maturity period of commercial paper mostly ranges from 91 to 180 days. It is sold at a discount from its face value and redeemed at face value on its maturity.  Working capital advance by commercial banks Working capital advance by commercial banks represents the most important source for financing current assets. Forms of Bank Finance: Working capital advance is provided by commercial banks in three primary ways: (i) cash credits / overdrafts, (ii) loans, and (iii) purchase / discount of bills. In addition to these forms of direct finance, commercials banks help their customers in obtaining credit from other sources through the letter of credit arrangement. Cash Credit / Overdrafts: Under a cash credit or overdraft arrangement, a pre-determined limit for borrowing is specified by the bank. The borrower can draw as often as required provided the out standings do not exceed the cash credit / overdraft limit. Loans: These are advances of fixed amounts which are credited to the current account of the borrower or released to him in cash. The borrower is charged with interest on the entire loan amount, irrespective of how much he draws. Purchase / Discount of Bills: A bill arises out of a trade transaction. The seller of goods draws the bill on the purchaser. The bill may be either clean or documentary (a documentary bill is supported by a document of title to gods like a railway receipt or a bill of lading) and may be payable on demand or after a
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  usance period whichdoes not exceed 90 days. On acceptance of the bill by the purchaser, the seller offers it to the bank for discount / purchase. When the bank discounts / purchases the bill it releases the funds to the seller. The bank presents the bill to the purchaser (the acceptor of the bill) on the due date and gets its payment. Letter of Credit: A letter of credit is an arrangement whereby a bank helps its customer to obtain credit from its (customer’s) suppliers. When a bank opens a letter of credit in favor of its customer for some specific purchases, the bank undertakes the responsibility to honor the obligation of its customer, should the customer fail to do so. Regulation ofBank Finance Concerned about such a distortion in credit allocation, the Reserve Bank of India (RBI) has been trying, particularly from the mid 1960s onwards, to bring a measure of discipline among industrial borrowers and to redirect credit to the priority sectors of the economy. From time to time, the RBI issues guidelines and directives relating to matters like the norms for inventory and receivables, the maximum permissible bank finance, the form of assistance, the information and reporting system, and the credit monitoring mechanism. The important guidelines and directives have stemmed from the recommendations of various committees such as the Dehejia Committee, the Tandon Committee, the Chore Committee, and the Marathe Committee. However, in recent years, in the wake of financial liberalization, the RBI has given freedom to the boards of individual banks in all matters relating to working capital financing. From the mid-eighties onwards, special committees were set up by the RBI to prescribe norms for several other industries and revise norms for some industries covered by the Tandon Committee. Inventory and receivable norms: Recommendations regarding inventory and receivable norms have been debated and criticized mostly. The committee pointed out that the borrower should be allowed to hold only a reasonable level of current assets, particularly inventory and receivables only the normal inventory, based on the production plan, lead time of supplies, economic ordering levels and reasonable factor of safety, should be financed by the banker. Receivables which are in tune with the practices of the borrower’s firm /industry should be financed. Lending Norms The recommendation of the Tandon Committee regarding the “Lending norms” has far - reaching implications. The lending norms have been suggested in view of the realization that the banker’s role as a lender in only to supplement the borrower’s resources and not to meet his entire working capitals needs. In the context of this approach, the committee has suggested three alternative methods for working out the maximum permissible level of bank borrowings. Each successive method reduces the involvement of short-term bank credit to finance the current assets. Maximum Permissible Bank Finance: The Tandon Committee had suggested three methods for determining the maximum permissible bank finance (MPBF).  First Method: According to this method, the borrower will have to contribute a minimum of 25% of the working capital gap from long-term funds, i.e., owned funds and term borrowings. This will give a current ratio of 1:17:1.The term working capital gap refers to the total of current assets less current liabilities other than bank borrowings.  Second Method: Under this method the borrower has to provide the minimum of 25% of the total current assets that will give a current ratio of 1.33:1.  Third Method : In this method, the borrower’s contribution from long term funds will be to the extent of the entire core current assets and a minimum of 25% of the balance of the current assets. The term core current assets refers to the absolute minimum level of investment in all current assets which is required at all times to carry out minimumlevel of business activities.
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  Reserve Bank’s directive:The Reserve Bank of India accepted the recommendations of the Tandon Committee. It instructed the commercial banks in 1976 to put all the borrowers having aggregate credit limits from banking system in excess of Rs. 10 lakhs, under the first method of lending.