WORKING CAPITAL FINANCING BY BANK

  CHAPTER – I THEORITICAL FRAMEWORK: Working Capital Management is concerned with the problems that arise in the attempt to manage the current assets, the current liabilities and the inter-relationship that exists between them. The aim of the working capital management is to manage the concerns current assets and current liabilities in such a way that an adequate level of the working capital is maintained. An adequate level of the working capital provides a business with operational flexibility. A business with an adequate level of working capital has more options available to it, and can make its own choices as to when working capital will be used and how it will be used; on the other hand, if a firm is short of working capital, it may be forced to limit business operations, extension of credit to customers and the amount that it invests inventory. This will adversely affect production as well as sales, which in turn will affect profitability of the concern. Working Capital Management is an integral part of overall financial management. It has been looked upon as the driving seat of the financial manager. Moves and actions in the operating fields of production, procurement, marketing and services are ultimately interpreted and view the financial terms. Hence, the preoccupation can be marked with the financial implications of the management of working capital and its segments. In the words of Louis Brandt : We need to know when to look for working capital funds, how to use them, and how to measure, plan and control them. Thus, it is concerned with obtaining economic funds, using them in a profitable manner and controlling them to maintain economy and profitability. Working Capital Management helps to establish a proper balance among risk, liquidity and profitability. Session Objectives: • Objective of Working Capital Management • Static view of working capital • Dynamic view of working capital • Evaluating working capital management TOPIC RELATED CONCEPTS: Working Capital Management: Working capital management is concerned with the problems that arise while managing current assets, current liabilities, and inter-relationship that exists between them. Current assets are those assets that, in ordinary course of business, can be converted into cash within one year without undergoing any diminution in value. The major current assets are cash, marketable securities, account serviceable, and inventory. In contrast to this, fixed assets are those assets that are permanent in nature and are held for use in business activities. For example, land, building, machinery etc. Current liabilities are those liabilities that are obligations that have to be paid in a single accounting period. Examples of current liabilities are accounts payable, bills receivable, bank over-draft and outstanding expenses. Long-term liabilities, on the other hand, are obligations that can be repaid over a period greater than a single accounting period. Examples of long-term liabilities are share capital, debentures, long-term loans etc. CONCEPTS OF WORKING CAPITAL: There are two concepts of working capital: a. Gross working capital: It is equal to the total investment in current assets. b. Net working capital: It is the difference between current assets and current liabilities. It can be described as that part of a firm’s current assets which is financed with the help of long-term funds. Both the concepts have equal significance in working capital management. Gross working capital helps in analyzing: a. Ways to optimize investment in current assets and b. Methods for financing current assets. Net working capital indicates the liquidity position of the firm. It also reflects the extent to which the working capital needs should be financed by long-term sources of funds. OBJECTIVE OF WORKING CAPITAL MANAGEMENT: The goal of working capital management is to manage the current assets and liabilities in such a way that an acceptable level of net working capital maintained. There are two issues that are dealt under working capital. They are: 1: Determining the level of working capital to be maintained : The exact amount of working capital that should be maintained varies from firm to firm and depends on various factors like nature of business, degree of competition etc. Keeping in view the uncertainty associated with the dynamic environment in which a firm operates, the amount of investments in current should assets be made in such a manner that it not only meets the needs of the forecasted sales but also provides a built-in cushion in the form of safety stocks to meet unforeseen contingencies arising out of factors such as delays in the arrival of raw materials, sudden spurts in sales demand etc. If a firm follows a conservative approach, then it will make a higher level of investment in current assets. But this would also mean that the company will not have sufficient amount to invest in profitable avenues. On the other hand, if the finance manager opts for an aggressive approach, the firm will have lesser investment in current assets thus leaving more amounts for investing in profitable alternatives. Thus, conservative approach provides more liquidity but less profitability and aggressive approach provides more profitability and less liquidity. 2: Decision regarding financing of current asset Once the appropriate level of working capital is chosen, the next decision pertains to determining the finance-mix for current assets. Some of the sources that are used to finance current assets are: a. Spontaneous liabilities: Short-term liabilities such as sundry creditors, accrued expenses, etc. and provisions that arise during the normal course of business serve as non-interest bearing source of financing current assets. b. Bank borrowings, Public deposits and long-term sources of finance The difference between the amounts of current assets and liabilities is usually financed through a combination of bank borrowings by way of cash credit/overdraft arrangement and long-term sources of finance such as debentures and equity capital. Companies can also opt for fixed deposits (obtained for a period of one to three years) for financing current assets. The decision regarding the financing of current assets using the above sources of finance depends on the attitude of the company towards risk. The financing policy opted by the firm can be classified into two categories based on its risk attitude a. Conservative financing policy: A firm following a conservative financing policy will use long-term sources like equity and debentures, for financing current assets. Consequently, these firms will have a lower risk as there is a reduced probability of “technical insolvency” that arises when a company is not in a position to honor its current liabilities. But following a conservative policy would imply a higher cost of financing since: I- . Equity has the highest cost of capital and it does not have the advantage of tax-deductibility that exists in the case of debt capital. ii. The interest on debentures has to be paid irrespective of the fluctuating needs for financing current assets. b. Aggressive financing policy: A firm following an aggressive financing policy will use more of bank borrowings and public deposits and less of long-term sources of finance for financing its current assets. Such a policy will be useful for companies that have a fluctuating need for current assets because usually the bank borrowings are geared to move in tandem with the fluctuating level of current assets so that the total interest charge for the company is likely to be low. But an aggressive financing policy involves higher risk of “technical insolvency.” Hence, depending upon the attitude of management towards risk and keeping in view the constraints imposed by banking sector with respect to short-term credit, the firm should choose the appropriate financing policy. STATIC VIEW OF WORKING CAPITAL As per the static view, working capital can be defined in two ways Gross working capital: It is equal to the total current assets (including loans and advances). Net working capital: It is the difference between current assets and current liabilities (including provisions). It can be also described as that part of a firm’s current assets which is financed with the help of long- term funds. The net working capital of a firm helps in comparing the liquidity of the same firm over a period of time. The liquidity of a firm can be defined as the ability of the firm to satisfy short-term obligations as they become due. The static view of working capital lays more emphasis on the level of current assets compared to the level of current liabilities. Drawbacks of static view of working capital: The static view of working capital has the following drawbacks: 1. The working capital under this view is computed using the data given in the balance sheet that is static in nature and fails to reflect the dynamic nature of working capital that is crucial in decision making. 2. The net working capital which is computed as the difference between current assets and current liabilities does not reflect the correct amount of working capital due to the following reasons: -Short-term bank borrowings that are used for financing current assets are shown separately under the heading of secured loans and not as a part of current liabilities. -Short-term Public deposits utilized for financing current assets are shown under the category of unsecured loans and are not included in current liabilities. -Short-term marketable securities that are held for the purpose of providing liquidity to the firm are shown under the heading of investments and are not included in the current assets. WORKING CAPITAL FINANCING   Abstract Working capital is the fund invested in current assets and is needed for meeting day to day expenses. Working capital is the fund invested in current assets. It occupies an important place in a firm’s Balance Sheet. Working capital financing is a specialized area and is designed to meet the working requirements of a business. The main sources of working capital financing are trade credit, bank credit, factoring and commercial paper. Out of all these, this paper is related only to bank credit which represents the most important source for financing of current assets. The firms generally enjoy easy access to the bank finance for meeting their working capital needs. But from time to time, Reserve Bank of India has been issuing guidelines and directives to the banks to strengthen the procedures and norms for working capital financing. This paper attempts to analyse the role of bank credit in financing working capital needs of firms. It also tries to give a bird’s eye view about the guidelines issued by RBI to banks in relation to working capital financing.  Working capital is that portion of a firm’s capital which is employed in short term operations. Current assets represent Gross Working Capital. The excess of current assets over current liabilities is Net Working Capital. Current assets consists of all stocks including finished goods, work in progress, raw material, cash, marketable securities, accounts receivables, inventories, short term investments, etc. These assets can be converted into cash within an accounting year. Current liabilities represent the total amount of short term debt which must be settled within one year. They represent creditors, bills payable, bank overdraft, outstanding expenses, short term loans, etc. The working capital is the finance required to meet the costs involved during the operating cycle or business cycle. Operating cycle is the period involved from the time raw materials are purchased to the time they are converted into finished goods and the same are finally sold and realized. The need for current assets arises because of operating cycle. The operating cycle is a continuous process and therefore the need for current assets is felt constantly. Each and every current asset is nothing but blockage of funds. Therefore, these current assets need to be financed which is done through Working Capital Financing There is always a minimum level of current assets or working capital which is continuously required by the firm to carry on its business operations. This minimum level of current assets is known as permanent or fixed working capital. It is permanent in the same way as the firm’s fixed assets are. This portion of working capital has to be financed by permanent sources of funds such as; share capital, reserves, debentures and other forms of long term borrowings. The extra working capital needed to support the changing production and sales is called fluctuating or variable or temporary working capital. This has to be financed on short term basis. The main sources for financing this portion are trade credit, bank credit, factoring and commercial paper. It is in this contex that bank financing assumes significance in the working capital financing of industrial concerns. A commercial bank is a business organization which deals in money i.e. lending and borrowing of money. They perform all types of functions like accepting deposits, advancing loans, credit creation and agency functions. Besides these usual functions, one of the most important functions of banks is to finance working capital requirement of firms. Working capital advances forms major part of advance portfolio of banks. IN determining working capital requirements of a firm, the bank takes into account its sales and production plans and desirable level of current assets. The amount approved by the bank for the firm’s working capital requirement is called credit limit. Thus, it is maximum fund which a firm can obtain from the bank. In the case of firms with seasonal businesses, the bank may approve separate limits for ‘peak season’ and ‘non-peak season’. These advances were usually given against the security of the current assets of the borrowing firm. Working capital financing is done by various modes such as trade credit, cash credit / bank overdraft, working capital loan, purchase of bills / discount of bills, bank guarantee, letter of credit, factoring, commercial paper, inter-corporate deposits etc.The arrangement of working capital financing forms a major part of the day to day activities of a finance manager. It is a very crucial activity and requires continuous attention because working capital is the money which keeps the day to day business operations smooth. Without appropriate and sufficient working capital financing, a firm may get into troubles. Insufficient working capital may result into nonpayment of certain dues on time. Inappropriate mode of financing would result in loss of interest which directly hits the profits of the firm. Types of Working Capital Financing:- Trade Credit:- This is simply the credit period which is extended by the creditor of the business. Trade credit is extended based on the creditworthiness of the firm which is reflected by its earning records, liquidity position and records of payment. Just like other sources of working capital financing, trade credit also comes with a cost after the free credit period. Normally, it is a costly source as a means of financing business working capital. Cash Credit / Bank Overdraft:  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. 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. Without a doubt, this is a cost effective working capital financing. Working Capital Loans:- 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. Short term corporate loans These will be demand loans of less than or upto 12 months’ tenor availed by borrowers to support temporary cash flow mismatches or to avail short-term interest rate arbitrage. Long Term corporate loans These will be demand loans of 12 months to 36 months’ tenor availed by borrowers to support long term augmentation of working capital , procurement of certain assets , cash flow mismatches etc. Purchase / Discount of Bills:  It is another good service provided by commercial banks for working capital financing. Every firm generates bills in the normal course of business while selling goods to debtors. Ultimately, that bill acts as a document to receive payment from the debtor. The seller who requires money will approach the bank with that bill and bank will apply discount on the total amount of the bill based on the prevailing interest rates and pay the remaining amount to the seller. On the date of maturity of that bill, the bank will approach the debtor and collect the money from him. Bank Guarantee: It is primarily known as non-fund based working capital financing. Bank guarantee is acquired by a buyer or seller to reduce the risk of loss to the opposite party due to non-performance of agreed task which may be repaying of money or providing of some services etc. A buyer ‘B1’ is buying some products from seller ‘S1’. In this case, ‘B1’ may acquire bank guarantee from the bank and give it to ‘S1’ to save him from the risk of nonpayment. Similarly, if ‘S1’ may acquire bank guarantee and hand it over to ‘B1’ to save him from the risk of getting lower quality goods or late delivery of goods etc. In essence, a bank guarantee is revoked by the holder only in case of non-performance by the other party. Bank charges some commission for same and may also ask for security. Letter of Credit: It is also known as non-fund based working capital financing. Letter of credit and bank guarantee has a very thin line of difference. Bank guarantee is revoked and the bank makes payment to the holder in case of non-performance of the opposite party whereas in the case of a letter of credit, the bank will pay the opposite party as soon as the party performs as per agreed terms. So, a buyer would buy a letter of credit and send it to the seller. Once the seller sends the goods as per the agreement, the bank would pay the seller and collects that money from the buyer. Sources of Working Capital:- Sources of working capital can be spontaneous, short term and long term. Spontaneous working capital includes mainly trade credit such as the sundry creditor, bills payable, and notes payable. Short term sources are tax provisions, dividend provisions, bank overdraft, cash credit, trade deposits, public deposits, bills discounting, short term loans, inter-corporate loans, and commercial paper. Long term sources are retained profits, provision for depreciation, share capital, long-term loans, and debentures. Spontaneous Sources Short Term Sources Long Term Sources Internal Sources External Sources Internal Sources External Sources Trade Credit Tax Provisions Bank Overdraft Retained Profits Share Capital Sundry Creditors Dividend Provisions Trade Deposits Depreciation Provision Long Term Loans Bills Payable   Public Deposits   Debentures Notes Payable   Bills Discounting      Accrued Expenses   Short Term Loans     SPONTANEOUS SOURCES OF WORKING CAPITAL FINANCE The word ‘spontaneous’ itself explains that this source of working capital is readily or easily available to the business in the normal course of business affairs. The quantum and terms of this credit depend on the industry norms and relationship between buyer and seller. These sources include trade credit allowed by the sundry creditors, credit from employees, and other trade-related credits. The biggest benefit of spontaneous sources as working capital is its effortless raising and insignificant cost compared to traditional ways of financing. The cost factor and the quantum depends a lot on the terms of such credit viz. maximum credit limit, the period of credit, and discount on cash payment. Each supplier will have a maximum credit limit defined for the buyer depending on the business capacity and creditworthiness of the buyer. Similarly, the credit period is defined say 30 days, 45 days etc. Discount on cash payment is allowed to the buyer if the payment immediately on buying the materials. This percentage of discount is an opportunity cost for the buyer. SHORT TERM SOURCES OF WORKING CAPITAL FINANCE Short term sources can be further divided into internal and external sources of working capital finance. The short-term internal sources include tax provisions, dividend provisions etc. Short-term external sources include short-term working capital financing from banks such as bank overdrafts, cash credits, trade deposits, bills discounting, short-term loans, inter-corporate loans, commercial paper, etc. Tax and dividend provisions are current liabilities and cannot be delayed. The fund that would have been used in paying these provisions act as working capital till the point these are not paid. Short term working capital finance availed from banks and financial institutions are costly compared to spontaneous and long-term sources in terms of rate of interest but have a great time flexibility. Due to time flexibility, the finance manager can use the funds and pay interest on the money which his business utilizes and can pay them anytime when cash is available. Overall, in comparison to long term sources where you have to hold funds even when not required, these facilities proves cheaper. LONG TERM SOURCES OF WORKING CAPITAL FINANCING Long term sources can also be divided into internal and external sources. Long term internal sources of finance are retained profits and provision for depreciation whereas external sources are Share Capital, long-term loan, and debentures. Retained profits and accumulated depreciation are as good as funds available to the business without any explicit cost. These are the funds completely earned and owned by the business itself. They are utilized for expansion as well as working capital finance. Long-term external sources of finance like share capital is a cheaper source of finance but are not commonly used for working capital finance. Working capital can be classified into temporary working capital and permanent working capital. It is advisable to use long term sources for permanent and short-term sources for temporary working capital requirements. This will optimize the working capital cost and enforce good working capital management practices. Working Capital: 8 Sources of Working Capital Finance – Explained. The two segments of working capital viz., regular or fixed or permanent and variable are financed by the long-term and the short-term sources of funds respectively. The main sources of long-term funds are shares, debentures, term- loans, retained earnings etc. The sources of short-term funds used for financing variable part of working capital mainly include the following: 1. Loans from commercial banks 2. Public deposits 3. Trade credit 4. Factoring 5. Discounting bills of exchange 6. Bank overdraft and cash credit 7. Advances from customers 8. Accrual accounts These are discussed in turn. 1. Loans from Commercial Banks: Small-scale enterprises can raise loans from the commercial banks with or without security. This method of financing does not require any legal formality except that of creating a mortgage on the assets. Loan can be paid in lump sum or in parts. The short-term loans can also be obtained from banks on the personal security of the directors of a country. Such loans are known as clean advances. Bank finance is made available to small- scale enterprises at concessional rate of interest. Hence, it is generally a cheaper source of financing working capital requirements of enterprise. However, this method of raising funds for working capital is a time-consuming process. 2. Public Deposits: Often companies find it easy and convenient to raise short- term funds by inviting shareholders, employees and the general public to deposit their savings with the company. It is a simple method of raising funds from public for which the company has only to advertise and inform the public that it is authorised by the Companies Act 1956, to accept public deposits. Public deposits can be invited by offering a higher rate of interest than the interest allowed on bank deposits. However, the companies can raise funds through public deposits subject to a maximum of 25% of their paid up capital and free reserves. But, the small-scale enterprises are exempted from the restrictions of the maximum limit of public deposits if they satisfy the following conditions: The amount of deposit does not exceed Rs. 8 lakhs or the amount of paid up capital whichever is less. (i) The paid up capital does not exceed Rs. 12 lakhs. (ii) The number of depositors is not more than 50%. (iii) There is no invitation to the public for deposits. The main merit of this source of raising funds is that it is simple as well as cheaper. But, the biggest disadvantage associated with this source is that it is not available to the entrepreneurs during depression and financial stringency. 3. Trade Credit: Just as the companies sell goods on credit, they also buy raw materials, components and other goods on credit from their suppliers. Thus, outstanding amounts payable to the suppliers i.e., trade creditors for credit purchases are regarded as sources of finance. Generally, suppliers grant credit to their clients for a period of 3 to 6 months. Thus, they provide, in a way, short- term finance to the purchasing company. As a matter of fact, availability of this type of finance largely depends upon the volume of business. More the volume of business more will be the availability of this type of finance and vice versa. Yes, the volume of trade credit available also depends upon the reputation of the buyer company, its financial position, degree of competition in the market, etc. However, availing of trade credit involves loss of cash discount which could be earned if payments were made within 7 to 10 days from the date of purchase of goods. This loss of cash discount is regarded as implicit cost of trade credit. 4. Factoring: Factoring is a financial service designed to help firms in managing their book debts and receivables in a better manner. The book debts and receivables are assigned to a bank called the 'factor' and cash is realised in advance from the bank. For rendering these services, the fee or commission charged is usually a percentage of the value of the book debts/receivables factored. This is a method of raising short-term capital and known as 'factoring'. On the one hand, it helps the supplier companies to secure finance against their book debts and receivables, and on the other, it also helps in saving the effort of collecting the book debts. The disadvantage of factoring is that customers who are really in genuine difficulty do not get the opportunity of delaying payment which they might have otherwise got from the supplier company. In the present context where industrial sickness is spreading like an epidemic, the reason for which particularly in SSI sector being delayed payments from their suppliers; there is a clear-cut rationale for introduction of factoring system. There has been some progress also on this front. The recommendations of the Study Group (RBI 1996) to examine the feasibility of setting up of factoring organisations in the country, under the Chairmanship of Shri C. S. Kalyanasundaram have been accepted by the Government of India. The Group is of the view that factoring for SSI units could prove to be mutually beneficial to both Factors and SSI units and Factors should make every effort to orient their strategy to crystallize the potential demand from the sector. 5. Discounting Bills of Exchange: When goods are sold on credit, bills of exchange are generally drawn for acceptance by the buyers of goods. The bills are generally drawn for a period of 3 to 6 months. In practice, the writer of the bill, instead of holding the bill till the date of maturity, prefers to discount them with commercial banks on payment of a charge known as discount. The term 'discounting of bills' is used in case of time bills whereas the term, 'purchasing of bills' is used in respect of demand bills. The rate of discount to be charged by the bank is prescribed by the Reserve Bank of India (RBI) from time to time. It generally amounts to the interest for the period from the date of discounting to the date of maturity of bills. If a bill is dishonoured on maturity, the bank returns the dishonoured bill to the company who then becomes liable to pay the amount to the bank. The cost of raising finance by this method is the amount of discount charged by the bank. This method is widely used by companies for raising short-term finance. 6. Bank Overdraft and Cash Credit: Overdraft is a facility extended by the banks to their current account holders for a short-period generally a week. A current account holder is allowed to withdraw from its current deposit account upto a certain limit over the balance with the bank. The interest is charged only on the amount actually overdrawn. The overdraft facility is also granted against securities. Cash credit is an arrangement whereby the commercial banks allow borrowing money up to a specified-limit known as 'cash credit limit.' The cash credit facility is allowed against the security. The cash credit limit can be revised from time to time according to the value of securities. The money so drawn can be repaid as and when possible. The interest is charged on the actual amount drawn during the period rather on limit sanctioned. The rate of interest charged on both overdraft and cash credit is relatively higher than the rate of interest given on bank deposits. Arranging overdraft and cash credit with the commercial banks has become a common method adopted by companies for meeting their short- term financial, or say, working capital requirements. 7. Advances from Customers: One way of raising funds for short-term requirement is to demand for advance from one's own customers. Examples of advances from the customers are advance paid at the time of booking a car, a telephone connection, a flat, etc. This has become an increasingly popular source of short-term finance among the small business enterprises mainly due to two reasons. First, the enterprises do not pay any interest on advances from their customers. Second, if any company pays interest on advances, that too at a nominal rate. Thus, advances from customers become one of the cheapest sources of raising funds for meeting working capital requirements of companies. 8. Accrual Accounts: Generally, there is a certain amount of time gap between incomes is earned and is actually received or expenditure becomes due and is actually paid. Salaries, wages and taxes, for example, become due at the end of the month but are usually paid in the first week of the next month. Thus, the outstanding salaries and wages as expenses for a week help the enterprise in meeting their working capital requirements. This source of raising funds does not involve any cost.  Spontaneous Sources Short Term Sources Long Term Sources Internal Sources External Sources Internal Sources External Sources Trade Credit Tax Provisions Bank Overdraft Retained Profits Share Capital Sundry Creditors Dividend Provisions Trade Deposits Depreciation Provision Long Term Loans Bills Payable   Public Deposits   Debentures Notes Payable   Bills Discounting      Accrued Expenses   Short Term Loans     6