The level of working capital needed can be evaluated as discussed and demonstrated under previous Section. How to finance this amount of working capital is the next concern.
Sources of Finance for Working Capital
Four categories are generally recognised :
(a) Trade credit;
(b) Bankcredit;
(c) Current provisions of non-bank short-term loans; and
(d) Long-term sources comprising equity capital and long-term loans.
The first two are more in vogue in India.
Trade Credit
Trade credit is a form of'short-term financing commonly availed in most businesses. Buyers are not required to pay for goods upon delivery but are allowed a short deferment period before payment is due, i.e. the seller extends credit to the buyer. There are three types of trade credit : open account, notes payable and trade acceptances.
Under the open account arrangement, the seller ships the goods to the buyer alongwith an invoice specifying the goods shipped, the p&e, the total amount due and the terms of the sale. The buyer does not sign a formal debt instrument evidencing the amount that he owes the seller. The seller extends credit based upon his credit investigation of the buyer.If promissory notes are employed evidencing the buyer's debt to the seller, it is the notes payable type of trade credit. In this, the buyer formally recognises his debt to the seller.
Under the trade acceptance arrangement, not only is the indebtedness of the buyer to the seller formally recognised; the seller draws a draft on the buyer ordering him to pay the draft at a specified future date. The sel!er releases the goods only after the buyer accepts the time draft. When the br yer accepts the draft, he designates a bank whereat the draft will be paid on the d ~ date
At the due date, the seller, as the holder of the acceptance, presents it to the designated bank for collection.The open account system is the most common, and notes payable system is followed but scarcely. Trade acceptance system is not much in favour (in India). In the open account system, the terms of the sale are very important. The following are the several categories of the terms :
(a) COD means cash on delivery of the goods. The only risk that the seller has to carry is if the buyer refuses to take the shipment.
(b) CBD means cash before delivery. This avoids all risk to the seller. In both COD and CBD, effectively no credit is extended by the seller. Progress Payment, in reality, are not trade credit at all; in this the buyer pays the manufacturer at various stages of production before the actual delivery of the finished product. When builders build aparhents for a group of members registered with them requiring periodic payments from the members as the construction proceeds, this constitutes progress payments.In most cases, progress payments are really advance pay.ments, quite the opposite of trade credit.
(c) net period-no cash discount : When credit is extended, the seller specifies the time allowed for payment, e.g. "net 30" indicates that the bill or the invoice must be paid within 30 days.
(d) Net period with cash discount : Even as credit is extended by the seller, he may also offer a cash discount if the bill is paid within an early part of the net period, e.g. "2/10, net 2 0 will mean that a 2% discount can be availed by the buyer if the bill is paid within 10 days: if not paid within 10 days,the full amount must be paid within 20 days. Such cash discount differs from trade discount and from quantity discount. The difference between cash discount and trade discount has been discussed in previous Unit. Cash discount is offered as an incentive to the buyer to pay early. Trade discount may be given to one type of customer (say to a wholesaler) and not another (say to a retailer or an individual buyer). Quantity discount is given to a customer when the shipment to him is above a certain amount.
(e) Datings : When the seller openly conveys his intention to encourage the customer to place his orders before a specified date to avoid any uncertainty in the mind of the seller as to the total numbers that may be sold (for which he has to organise his production schedule), this is called dating the sales. The seller may charge a lesser cost or may extend a longer duration of credit.
Trade credit (as a liability on the buyer) is a source of funds (for the buyer)since the buyer does not have to pay for the goods until after they are delivered.As accounts payable increase, they provide part of the funds needed as working
capital.
Bank Credit
Bank credit is the primary institutional source for financing working capital. To obtain short-term bank credit, working capital needs are estimated on the lines of the Illustrative Examples; and further details according to proformae are forwarded to the bank. The bank determines the maximum credit allowable based on asset offered as security by the borrower. If the bank is prepared to provide credit upto, say, 60% of the value of the asset offered as security, this 60% is defined as the margin requirement on the item offered as security. This margin is as per stipulations from time to time of the Reserve Bank of India. Bank credit availed can be in different forms.If availed as a loan, the amount of loan is credited to the borrower's account by the bank. Loan is to be repaid in instalments with interest on the balance outstanding.
If availed as an overdraft arrangement, the borrower can overdraw cumulatively on his current account upto the stipulated limit, through any number of occasions of borrowing. Repayments can be made at any time during the validity of the arrangement. Interest liability of the borrower is on the actual amount borrowed.If availed by a cash credit arrangement, the borrower can draw cumulatively by any number of times upto the stipulated limit but should also pay a certain (small) percentage as commitment charges on the unutilised balance during the period of validity of the arrangement. There are possibilities of cash credit arrangement being misused primarily because the borrower can pledge or hypothecate alternative securities from time to time which works as follows. Firm A purchases goods worth, say, Rs. 1 lakh, pledges it with the bank and borrows Rs. 60,000; buys goods for, say, Rs. 50,000 out of this Rs. 60,000; again pledges these goods with the bank to borrow, say, Rs. 30,000. This type of managing double financing has been the prevalent misuse of cash credit arrangement.
To overcome this misuse, the scheme "bills purchased and bills discounted' has come into practice. This is also called Bill Market Scheme. The borrower may purchase goods from the market, get the bills and present them to the bank for discounting. Having satisfied to itself on the creditworthiness of the borrower and on the genuineness of the bill, the loan is processed subject to the cash credit limit.The comprehensive procedure can have more complicated steps.Banks may also advance term loans for longer periods of 3-7 years repayable in yearly or half-yearly instalments against security. Of course, there are several modes of security - viz. hypothecation, pledge, lien, mortgage, charge, etc. Details of these modes art not taken up for discussion herein.
The Report of the Tandon Committee, constituted as a Study Group by the Reserve Bank of India in July 1974, contains detailed guidelines regarding providing bank credit for working capital needs. The core of the recommendations is to enforce a progression of 3 stages resulting in reducing the maximum bank borrowings permissible. Norms have been suggested for 15 major industries. Details of the recommendations are not taken up herein. Briefly, banking policy affects the financing of working capital by credits or loans.
Non-bank Short-term Borrowings
Firms may resort to seeking fixed deposits from the general public as also redeemable debentures. Credit-ratings are made of the firm by acknowledged and renowned agencies for the benefit of the potential investors. Interest rates that may be offered are subject to ceilings by government stipulations. Commercial paper is another instrumentality in this category.
Long-term Sources Comprising Equity Capital and Long-term Borrowings.The issue of bonus shares is one way of retaining the profits within the firm to increase its cash resources with simultaneously satisfying the equity holders to some extent - increasing the equity base at the same time. Under extreme situations, long-term borrowings can also be resorted to for augmenting the cash resources of the firm for its working capital;
Sources of Finance for Working Capital
Four categories are generally recognised :
(a) Trade credit;
(b) Bankcredit;
(c) Current provisions of non-bank short-term loans; and
(d) Long-term sources comprising equity capital and long-term loans.
The first two are more in vogue in India.
Trade Credit
Trade credit is a form of'short-term financing commonly availed in most businesses. Buyers are not required to pay for goods upon delivery but are allowed a short deferment period before payment is due, i.e. the seller extends credit to the buyer. There are three types of trade credit : open account, notes payable and trade acceptances.
Under the open account arrangement, the seller ships the goods to the buyer alongwith an invoice specifying the goods shipped, the p&e, the total amount due and the terms of the sale. The buyer does not sign a formal debt instrument evidencing the amount that he owes the seller. The seller extends credit based upon his credit investigation of the buyer.If promissory notes are employed evidencing the buyer's debt to the seller, it is the notes payable type of trade credit. In this, the buyer formally recognises his debt to the seller.
Under the trade acceptance arrangement, not only is the indebtedness of the buyer to the seller formally recognised; the seller draws a draft on the buyer ordering him to pay the draft at a specified future date. The sel!er releases the goods only after the buyer accepts the time draft. When the br yer accepts the draft, he designates a bank whereat the draft will be paid on the d ~ date
At the due date, the seller, as the holder of the acceptance, presents it to the designated bank for collection.The open account system is the most common, and notes payable system is followed but scarcely. Trade acceptance system is not much in favour (in India). In the open account system, the terms of the sale are very important. The following are the several categories of the terms :
(a) COD means cash on delivery of the goods. The only risk that the seller has to carry is if the buyer refuses to take the shipment.
(b) CBD means cash before delivery. This avoids all risk to the seller. In both COD and CBD, effectively no credit is extended by the seller. Progress Payment, in reality, are not trade credit at all; in this the buyer pays the manufacturer at various stages of production before the actual delivery of the finished product. When builders build aparhents for a group of members registered with them requiring periodic payments from the members as the construction proceeds, this constitutes progress payments.In most cases, progress payments are really advance pay.ments, quite the opposite of trade credit.
(c) net period-no cash discount : When credit is extended, the seller specifies the time allowed for payment, e.g. "net 30" indicates that the bill or the invoice must be paid within 30 days.
(d) Net period with cash discount : Even as credit is extended by the seller, he may also offer a cash discount if the bill is paid within an early part of the net period, e.g. "2/10, net 2 0 will mean that a 2% discount can be availed by the buyer if the bill is paid within 10 days: if not paid within 10 days,the full amount must be paid within 20 days. Such cash discount differs from trade discount and from quantity discount. The difference between cash discount and trade discount has been discussed in previous Unit. Cash discount is offered as an incentive to the buyer to pay early. Trade discount may be given to one type of customer (say to a wholesaler) and not another (say to a retailer or an individual buyer). Quantity discount is given to a customer when the shipment to him is above a certain amount.
(e) Datings : When the seller openly conveys his intention to encourage the customer to place his orders before a specified date to avoid any uncertainty in the mind of the seller as to the total numbers that may be sold (for which he has to organise his production schedule), this is called dating the sales. The seller may charge a lesser cost or may extend a longer duration of credit.
Trade credit (as a liability on the buyer) is a source of funds (for the buyer)since the buyer does not have to pay for the goods until after they are delivered.As accounts payable increase, they provide part of the funds needed as working
capital.
Bank Credit
Bank credit is the primary institutional source for financing working capital. To obtain short-term bank credit, working capital needs are estimated on the lines of the Illustrative Examples; and further details according to proformae are forwarded to the bank. The bank determines the maximum credit allowable based on asset offered as security by the borrower. If the bank is prepared to provide credit upto, say, 60% of the value of the asset offered as security, this 60% is defined as the margin requirement on the item offered as security. This margin is as per stipulations from time to time of the Reserve Bank of India. Bank credit availed can be in different forms.If availed as a loan, the amount of loan is credited to the borrower's account by the bank. Loan is to be repaid in instalments with interest on the balance outstanding.
If availed as an overdraft arrangement, the borrower can overdraw cumulatively on his current account upto the stipulated limit, through any number of occasions of borrowing. Repayments can be made at any time during the validity of the arrangement. Interest liability of the borrower is on the actual amount borrowed.If availed by a cash credit arrangement, the borrower can draw cumulatively by any number of times upto the stipulated limit but should also pay a certain (small) percentage as commitment charges on the unutilised balance during the period of validity of the arrangement. There are possibilities of cash credit arrangement being misused primarily because the borrower can pledge or hypothecate alternative securities from time to time which works as follows. Firm A purchases goods worth, say, Rs. 1 lakh, pledges it with the bank and borrows Rs. 60,000; buys goods for, say, Rs. 50,000 out of this Rs. 60,000; again pledges these goods with the bank to borrow, say, Rs. 30,000. This type of managing double financing has been the prevalent misuse of cash credit arrangement.
To overcome this misuse, the scheme "bills purchased and bills discounted' has come into practice. This is also called Bill Market Scheme. The borrower may purchase goods from the market, get the bills and present them to the bank for discounting. Having satisfied to itself on the creditworthiness of the borrower and on the genuineness of the bill, the loan is processed subject to the cash credit limit.The comprehensive procedure can have more complicated steps.Banks may also advance term loans for longer periods of 3-7 years repayable in yearly or half-yearly instalments against security. Of course, there are several modes of security - viz. hypothecation, pledge, lien, mortgage, charge, etc. Details of these modes art not taken up for discussion herein.
The Report of the Tandon Committee, constituted as a Study Group by the Reserve Bank of India in July 1974, contains detailed guidelines regarding providing bank credit for working capital needs. The core of the recommendations is to enforce a progression of 3 stages resulting in reducing the maximum bank borrowings permissible. Norms have been suggested for 15 major industries. Details of the recommendations are not taken up herein. Briefly, banking policy affects the financing of working capital by credits or loans.
Non-bank Short-term Borrowings
Firms may resort to seeking fixed deposits from the general public as also redeemable debentures. Credit-ratings are made of the firm by acknowledged and renowned agencies for the benefit of the potential investors. Interest rates that may be offered are subject to ceilings by government stipulations. Commercial paper is another instrumentality in this category.
Long-term Sources Comprising Equity Capital and Long-term Borrowings.The issue of bonus shares is one way of retaining the profits within the firm to increase its cash resources with simultaneously satisfying the equity holders to some extent - increasing the equity base at the same time. Under extreme situations, long-term borrowings can also be resorted to for augmenting the cash resources of the firm for its working capital;
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