WORKING CAPITAL FINANCING

Accrued Expenses and Income in AdvanceAccrued ExpensesAccrued Wages and Salaries.Accrued taxes and Interest.Accruals vary with the level of activity of the firm.Generally not controllable by management.Income in AdvanceAdvance Payments received.

Trade credit represents the credit extended by the suppliers of goods and services in the normal course of business. An informal arrangement, granted on an open account basis, not formally acknowledged as a debt.May also take the form of bills payable.Spontaneous source of finance.i.e. obtained in normal course of business, no formal negotiation.Confidence of suppliers key to securing trade credit.Trade Credit

Pros and Cons of Trade creditAdvantagesEasy Availability.Flexibility.Informality (No Restrictions).DisadvantagesImplicit Cost in case cash discount is offered by supplier.The cost of trade credit is:

Stretching A/P can prove to be very costly.

Example:The credit terms are 2/15, net 45. What is the cost of trade credit?

Commercial PaperUnsecured negotiable promissory notes issued at a discount by from face value firms to raise short-term funds.The effective pre-tax cost of commercial paper or implied yield is:

Sales price is net amount realised

Example:A firm sells 120-day commercial paper (Rs 100 face value for Rs 96 net, determine the interest yield.A company issues a 90-day CP of a face value of Rs 1000 at Rs 985. The credit rating expenses are 0.5 per cent of the size of issue, IPA(Issue and Paying) charges being 0.35 percent and stamp duty 0.5 percent. What is the cost of CP?

Features of Commercial PaperIssuer requirements:Tangible Net worth Rs.4 crSanctioned working capital limit from a bank/FI and the borrowal account is a standard assetMaturity -7 days 1 yrRating-Issued by firms which enjoy a fairly high credit rating, P-2 of CRISIL.Denomination : Rs. 5 lakhs and multiples thereof

Merits and Demerits of Commercial Paper

MeritsAlternative Source of Finance for well rated cos.High Liquidity in Money Market.Relatively Low Cost of C.P.Flexibility Maturities tailored to match issuers cashflowsDemeritsOnly available to financially sound companies.Can not be redeemed until maturity.Limited to the amount of excess liquidity of purchasers.

A deposit made by one company with another, normally for a period up to six months Typically unsecured and arranged by financier.Interest rate depends on amount and time periodLimits:50% of the Net Owned Funds Minimum tenor of borrowing: 7 days.Usually of three types: Call deposits, three-month deposits, and six-month deposits.Inter-corporate Deposits

Bank Finance for Working CapitalOverdraftCash CreditPurchase or Discounting of BillsLetter of CreditWorking Capital Loan

Security for Bank FinanceHypothecationPledge

Regulation of Bank FinanceDehejia 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.

Dehejia CommitteeExisting DeficienciesDifficulty in credit planning by lender- amount of credit is borrower decisionThe bank credit treated 1st source of finance instead of supplementary sourceCredit amount based on security available, not borrowers level of operationsEfficient follow-up of the industrial operations of the borrower ensures safety of bank funds not security.

The Tandon Committee RecommendationsNorms for current assetsMaximum permissible Bank Finance (MPBF)Emphasis on Loan SystemPeriodic Information and Reporting System:

The Tandon Committee RecommendationsPeriodic Information and Reporting System:Quarterly infor. System-Form I-Production and sales estimates for the current year and the subseq. qtrEstimates of assets and liabilities for subseq. QtrQuarterly infor. System-Form II-Actual production and sales- completed and current year Actual current assets and liab. for completed qtr.Half yearly operating statements- Form III: actual operating performance for half-yr ended and its estimatesHalf yearly operating statements- Form IIIB: actual sources and uses for half-yr ended and its estimates

The Chore Committee RecommendationsReduced Dependence on Bank Credit.Credit limit to be separated into peak level and normal peak level limits.Existing Lending System to Continue.Information System.

Tandon Committee had suggested three methods for determining the MPBFMethod 1 : MPBF = 0.75 (CA CL)Method 2 : MPBF = 0.75 (CA) CLMethod 3 : MPBF = 0.75 (CA CCA) CLCA = current assetsCL = non-banking current liabilitiesCCA = core current assetsMaximum Permissible Bank Finance (MPBF)

Example:The following are the details of current assets and current liabilities of ABC Ltd. find out the MPBF as per the 3 methods suggested by the Tandon Committee.

Current assets Rs in lacsCurrrent LiabilitiesRs in lacsRaw material200Creditors 250Work- in-progress100Other current liabilities50Finished goods200Bank borrowing300Receivables 300Other current assets50Total 850600

Present PracticeAssessment of working capital requirements:Projected balance sheet methodCash budget methodTurnover method (earlier Nayak committee recommended loan of 20% of turnover for borrowers with WC limits

These are unsecured deposits from the public. Public deposits cannot exceed 25 percent of share capital and free reserves. The maximum maturity period allowed for public deposits is 3 years. However, for NBFCs it is 5 years.PUBLIC DEPOSITS

A company can issue rights debentures to its shareholders to augment the long-term source for working capital requirements The key guidelines applicable to rights debentures relate to the quantum of such issues and the debt : equity ratio (

Factoring

Factoring involves provision of specialised services relating to credit investigation, sales ledger management, purchase and collection of debts, credit protection provisions of finance against receivables and risk bearing. In factoring, accounts receivables are generally sold to a financial institution that charges commission and bears the credit risks associated with it.

FACTORING

1

Places order

3

Delivers goods and

invoice with notice

to pay the factor

4 8 6

Sends Pays Follows

invoice balance up

copy amount

2 7

Fixes 5 Pays

Prepays

limit up to

80%

CUSTOMER

(BUYER)

CLIENT

(SELLER)

FACTOR

Benefits of Factoring

(i) The firm can convert accounts receivables into cash without bothering about repayment.(ii) A definite pattern of cash inflows.(iii) Eliminates the need for credit department- Continuous factoring virtually (iv) Unlike an unsecured loan, compensating balances are not required in this case.Another advantage consists of relieving the borrowing firm of substantial credit and collection costs and to a degree from a considerable part of cash management.