WORKING CAPITAL FINANCE

LEARNING OBJECTIVES

Explain the benefits and costs of trade credit Focus on the norms used by banks in financing a

firm’s working capital need Emphasize the importance of commercial paper as

a method of working capital finance in India

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Short-term Sources of Finance

Trade Credit Accrued Expenses and Deferred Income Bank Borrowings Factoring of receivables Commercial Paper

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Trade Credit and Credit Terms

Refers to the credit that the customer gets from supplier of goods in normal course of business.

An informal arrangement, granted on an open account basis, not formally acknowledge as a debt.

Trade credit may also take the form of bills payable.

Credit Terms refers to the conditions of due date and cash discount.

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Benefits and Costs of Trade Credit Benefits

1. Easy Availability.

2. Flexibility.

3. Informality.

Costs1. Implicit Cost.

2. Stretching A/P can prove to be very costly.

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Suppliers sometimes offer cash discount to buyers for making prompt payment. Buyer should calculate the cost of foregoing cash discount to decide whether or not cash discount should be availed. The following formula can be used:

Suppliers sometimes offer cash discount to buyers for making prompt payment. Buyer should calculate the cost of foregoing cash discount to decide whether or not cash discount should be availed. The following formula can be used:

Cost of cash discount6

ACCRUED EXPENSES AND DEFERRED INCOME

Accrued Expenses Accrued expenses represent a liability that a firm has to

pay for the services which it has already received.

1. Accrued Wages and Salaries.

2. Accrued taxes and Interest.

Deferred Income Deferred income represents funds received by the firm

for goods and services which it has agreed to supply in future.

1. Advance Payments.

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Bank Finance for Working Capital Overdraft Cash Credit Purchase or Discounting of Bills Letter of Credit Working Capital Loan

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Security for Bank Finance Hypothecation Pledge Mortgage Lien

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Regulation of Bank Finance Dehejia Committee (1968) Tandon Committee (1974) Chore Committee (1979)

In the deregulated economic environment in India recently, banks have considerably relaxed their criteria of lending. In fact, each bank can develop its own criteria for the working capital finance.

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Dehejia Committee–Existing Deficiencies

It is the borrower who decides how much he would borrow; the banker does not decide how much he would lend and is, therefore not in a position to do credit planning.

The bank credit is treated as first source of finance and not as supplementary to other source of finance.

The amount of credit extended is based on the amount of security available, not on the level of operations of borrower.

Security does not by itself ensure safety of bank funds since all bad and sticky advances are secured advances; safety essentially lies in the efficient follow-up of the industrial operations of the borrower.

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The Tandon Committee-Notions

Operating Plan Production Based Financing Partial Bank Financing

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The Tandon Committee-Recommendations1. Inventory and receivable norms

2. Lending norms

3. Maximum Permissible Bank Finance (MPBF) First method Second method Third method

4. Style of credit

5. Information system

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The Chore Committee-Recommendations

1. Reduced Dependence on Bank Credit.

2. Credit limit to be separated into “peak level” and “normal non-peak level” limits.

3. Existing Lending System to Continue.

4. Information System.

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COMMERCIAL PAPER

Unsecured promissory notes issued by firms to raise short-term funds.

In India, it was introduced in 1989 on recommendation of the “Vaghul Working Group”.

Commercial papers sell at a discount from face value.

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Merits

1. It is an alternative source of raising short-term finance.

2. It is a cheaper source of finance in comparison to the bank credit.

3. From an investor’s point of view, it provides an opportunity to make a safe, short-term investment of surplus funds.

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Demerits

1. It is an impersonal method of financing.

2. A firm facing temporary liquidity problems may not be able to raise funds by issuing new paper.

3. The amount of loanable funds available in the commercial paper market is limited to the amount of excess liquidity of the various purchasers of commercial paper.

4. It cannot be redeemed until maturity.

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