Concepts of Working Capital and Short Term Finance

CONCEPT OF WORKING CAPITAL

Working capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business, organization, or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities.

Working Capital = Current Assets

Net Working Capital = Current Assets − Current Liabilities

Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable and cash.

WORKING CAPITAL MANAGEMENT

Working Capital Management is concerned with the problems that arise in attempting to manage the Current Assets, Current Liabilities and the inter-relationship that exists between them.

Working Capital Management means the deployment of current assets and current liabilities efficiently so as to maximize short-term liquidity

Working capital management entails short term decisions – generally, relating to the next one year period – which is “reversible”

Two Steps involved in the Working Capital Management:

– Forecasting the Amount of Working Capital

– Determining the Sources of Working Capital

SHORT TERM WC FINANCING

DEFINITION

Short term WC financing is essentially providing businesses funds for a short term period of a year or less. These funds are usually used by businesses to finance their WC requirements i.e. run their day-to-day operations including payment of wages to employees, inventory ordering and supplies etc.

Get Help With Your Essay

If you need assistance with writing your essay, our professional essay writing service is here to help!
Find out more about our Essay Writing Service

PURPOSE OF SHORT TERM FINANCE

After establishment of a business, funds are required to meet its day to day expenses. For example raw materials must be purchased at regular intervals, workers must be paid wages regularly, water and power charges have to be paid regularly. Thus there is a continuous necessity of liquid cash to be available for meeting these expenses. For financing such requirements short-term funds are needed. The availability of short-term funds is essential. Inadequacy of short-term funds may even lead to closure of business.

Short-term finance serves following purposes:

1. It facilitates the smooth running of business operations by meeting day to day financial requirements.

2. It enables firms to hold stock of raw materials and finished product.

3. With the availability of short-term finance goods can be sold on credit. Sales are for a certain period and collection of money from debtors takes time. During this time gap, production continues and money will be needed to finance various operations of the business.

4. Short-term finance becomes more essential when it is necessary to increase the volume of production at a short notice.

5. Short-term funds are also required to allow flow of cash during the operating cycle. Operating cycle refers to the time gap between commencement of production and realisation of sales.

SOURCES OF SHORT TERM FINANCE

There are a number of sources of short-term finance which are listed below:

1. Trade credit

2. Bank credit

– Loans and advances

– Cash credit

– Overdraft

– Discounting of bills

3. Customers’ advances

4. Installment credit

5. Loans from co-operatives

1. TRADE CREDIT

Trade credit refers to credit granted to manufactures and traders by the suppliers of raw material, finished goods, components, etc. Usually business enterprises buy supplies on a 30 to 90 days credit. This means that the goods are delivered but payments are not made until the expiry of period of credit. This type of credit does not make the funds available in cash but it facilitates purchases without making immediate payment. This is quite a popular source of finance.

2. BANK CREDIT

Commercial banks grant short-term finance to business firms which are known as bank credit. When bank credit is granted, the borrower gets a right to draw the amount of credit at one time or in installments as and when needed. Bank credit may be granted by way of loans, cash credit, overdraft and discounted bills.

(i) LOANS

When a certain amount is advanced by a bank repayable after a specified period, it is known as bank loan. Such advance is credited to a separate loan account and the borrower has to pay interest on the whole amount of loan irrespective of the amount of loan actually drawn. Usually loans are granted against security of assets.

(ii) CASH CREDIT

It is an arrangement whereby banks allow the borrower to withdraw money up to a specified limit. This limit is known as cash credit limit. Initially this limit is granted for one year. This limit can be extended after review for another year. However, if the borrower still desires to continue the limit, it must be renewed after three years. Rate of interest varies depending upon the amount of limit.

Banks ask for collateral security for the grant of cash credit. In this arrangement, the borrower can draw, repay and again draw the amount within the sanctioned limit. Interest is charged only on the amount actually withdrawn and not on the amount of entire limit.

(iii) OVERDRAFT

When a bank allows its depositors or account holders to withdraw money in excess of the balance in his account up to a specified limit, it is known as overdraft facility. This limit is granted purely on the basis of credit-worthiness of the borrower. Banks generally give the limit up to Rs.20, 000. In this system, the borrower has to show a positive balance in his account on the last Friday of every month. Interest is charged only on the overdrawn money. Rate of interest in case of overdraft is less than the rate charged under cash credit.

(iv) DISCOUNTING OF BILL

Banks also advance money by discounting bills of exchange, promissory notes and hundies. When these documents are presented before the bank for discounting, banks credit the amount to customer’s account after deducting discount. The amount of discount is equal to the amount of interest for the period of bill. This part has been discussed in detail later on in this chapter.

3. CUSTOMER’S ADVANCES

Sometimes businessmen insist on their customers to make some advance payment. It is generally asked when the value of order is quite large or things ordered are very costly. Customers’ advance represents a part of the payment towards price on the product (s) which will be delivered at a later date. Customers generally agree to make advances when such goods are not easily available in the market or there is an urgent need of goods. A firm can meet its short-term requirements with the help of customers’ advances.

4. INSTALLMENT CREDIT

Installment credit is now-a-days a popular source of finance for consumer goods like television, refrigerators as well as for industrial goods. You might be aware of this system. Only a small amount of money is paid at the time of delivery of such articles. The balance is paid in a number of installments. The supplier charges interest for extending credit. The amount of interest is included while deciding on the amount of installment. Another comparable system is the hire purchase system under which the purchaser becomes owner of the goods after the payment of last installment. Sometimes commercial banks also grant installment credit if they have suitable arrangements with the suppliers.

5. LOANS FROM CO-OPERATIVE BANKS

Co-operative banks are a good source to procure short-term finance. Such banks have been established at local, district and state levels. District Cooperative Banks are the federation of primary credit societies. The State Cooperative Bank finances and controls the District Cooperative Banks in the state. They are also governed by Reserve Bank of India regulations. Some of these banks like the Vaish Co-operative Bank was initially established as a co-operative society and later converted into a bank. These banks grant loans for personal as well as business purposes. Membership is the primary condition for securing loan. The functions of these banks are largely comparable to the functions of commercial banks.

MERITS OF SHORT TERM FINANCE

a) Economical : Finance for short-term purposes can be arranged at a short notice and does not involve any cost of raising. The amount of interest payable is also affordable. It is, thus, relatively more economical to raise short-term finance.

b) Flexibility: Loans to meet short-term financial need can be raised as and when required. These can be paid back if not required. This provides flexibility.

c) No interference in management: The lenders of short-term finance cannot interfere with the management of the borrowing concern. The management retains their freedom in decision making.

d) May also serve long-term purposes: Generally business firms keep on renewing short-term credit, e.g., cash credit is granted for one year but it can be extended up to 3 years with annual review. After three years it can be renewed. Thus, sources of short-term finance may sometimes provide funds for long-term purposes.

DEMERITS OF SHORT TERM FINANCE

a) Fixed Burden: Like all borrowings interest has to be paid on short-term loans irrespective of profit or loss earned by the organisation. That is why business firms use short-term finance only for temporary purposes.

b) Charge on assets: Generally short-term finance is raised on the basis of security of moveable assets. In such a case the borrowing concern cannot raise further loans against the security of these assets nor can these be sold until the loan is cleared (repaid).

c) Difficulty of raising finance: When business firms suffer intermittent losses of huge amount or market demand is declining or industry is in recession, it loses its creditworthiness. In such circumstances they find it difficult to borrow from banks or other sources of short-term finance.

d) Uncertainty: In cases of crisis business firms always face the uncertainty of securing funds from sources of short-term finance. If the amount of finance required is large, it is also more uncertain to get the finance.

e) Legal formalities: Sometimes certain legal formalities are to be complied with for raising finance from short-term sources. If shares are to be deposited as security, then transfer deed must be prepared. Such formalities take lot of time and create lot of complications.

METHODS TO COMPUTE WORKING CAPITAL FINANCE

1. OPERATING CYCLE METHOD

WC = OPERATING EXPENSES / NO. OF OPERATING CYCLES IN A YEAR

A – Length of operating cycle

a. Procurement of raw materials

b. Conversion/process time

c. Average time of holding FG

d. Average collection period

e. Operating Cycle (a + b + c + d)

f. Operating cycle in a year (360/e)

B – Total operating expenses per annum

C – Working Capital Requirement ( B/f)

2. TURNOVER METHOD

(Applicable for limits up to Rs. 6 crores)

A. Sales Turnover

B. 25% of sales turnover

C. 5% of sales turnover projected as margin

D. Actual NWC existing as per last financial statement

E. B – C

F. B – D

G. MBPF ( E or F whichever is less)

H. Additional margin to be brought in ( C – D )

3. CASH BUDGET METHOD

Cash inflow – Cash outflow = Bank finance in the form of working capital

Months 1 2 3 4 5 6 7 8 9 10 11 12

Cash receipts(1)

Cash payments(2)

Suplus/Deficit( 1 – 2)

Peak deficit is financed and drawings are regulated by monthly budgets.

CONCEPT OF WORKING CAPITAL GAP:

THE TANDON COMMITTEE RECOMMENDATIONS

Like many other activities of the banks, method and quantum of short-term finance that can be granted to a corporate was mandated by the Reserve Bank of India till 1994. This control was exercised on the lines suggested by the recommendations of a study group headed by Shri Prakash Tandon. The study group headed by Shri Prakash Tandon, the then Chairman of Punjab National Bank, was constituted by the RBI in July 1974 with eminent personalities drawn from leading banks, financial institutions and a wide cross-section of the Industry with a view to study the entire gamut of Bank’s finance for working capital and suggest ways for optimum utilisation of Bank credit. This was the first elaborate attempt by the central bank to organise the Bank credit. The report of this group is widely known as Tandon Committee report.

As per the recommendations of Tandon Committee, the corporates should be discouraged from accumulating too much of stocks of current assets and should move towards very lean inventories and receivable levels. The committee even suggested the maximum levels of Raw Material, Stock-in-process and Finished Goods which a corporate operating in an industry should be allowed to accumulate These levels were termed as inventory and receivable norms. Depending on the size of credit required, the funding of these current assets (working capital needs) of the corporates could be met by one of the following methods:

FIRST METHOD OF LENDING: Banks can work out the working capital gap, i.e. total current assets less current liabilities other than bank borrowings (called Maximum Permissible Bank Finance or MPBF) and finance a maximum of 75 per cent of the gap; the balance to come out of long-term funds, i.e., owned funds and term borrowings. This approach was considered suitable only for very small borrowers i.e. where the requirements of credit were less than Rs.10 lacs

Total Current Assets

– Total Current Liabilities

= Working Capital Gap

– 25% from long term sources

= MPBF

SECOND METHOD OF LENDING :Under this method, it was thought that the borrower should provide for a minimum of 25% of total current assets out of long-term funds i.e., owned funds plus term borrowings. A certain level of credit for purchases and other current liabilities will be available to fund the build up of current assets and the bank will provide the balance (MPBF). Consequently, total current liabilities inclusive of bank borrowings could not exceed 75% of current assets. RBI stipulated that the working capital needs of all borrowers enjoying fund based credit facilities of more than Rs. 10 lacs should be appraised (calculated) under this method.

Total Current Assets

– 25% from long term sources

= Net Current Assets

– Total Current Liabilities

= MBPF

THIRD METHOD OF LENDING: Under this method, the borrower’s contribution from long term funds will be to the extent of the entire CORE CURRENT ASSETS, which has been defined by the Study Group as representing the absolute minimum level of raw materials, process stock, finished goods and stores which are in the pipeline to ensure continuity of production and a minimum of 25% of the balance current assets should be financed out of the long term funds plus term borrowings.

Total Current Assets

– Core Current Assets

= Net WC Current Assets

– 25% from long term sources

= Net Current Assets

– Total Current Liabilities

= MPBF

# Note: Total Current Liabilities means Liabilities excluding Bank Borrowings to be taken into account for Calculation