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 that keeps the day-to-day business operations smooth. A firm may get into trouble without appropriate and sufficient working capital financing. Insufficient working capital may result in the non-payment of certain dues on time. An inappropriate mode of financing would result in a loss of interest, which directly hits the profits of the firm.
This is simply the credit period that 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 that 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 costs. Without a doubt, this is a cost-effective working capital financing.
Working Capital Loans
Working capital loans are as good as term loans for a short period. These loans may be repaid in installments or a lump sum at the end. The borrower should take such loans to finance permanent working capital needs. The cost of interest would not allow using such loans for temporary working capital.
For a business, 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 the bank will apply the 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.
It is primarily known as non-fund-based working capital financing. A Bank guarantee is acquired by a buyer or seller to reduce the risk of loss to the opposite party due to non-performance of the agreed task, which may be repaying the money or providing of some services etc. A buyer ‘B1’ is buying some products from seller ‘S1’. In this case, ‘B1’ may acquire a bank guarantee from the bank and give it to ‘S1’ to save him from the risk of nonpayment. Similarly, if ‘S1’ may acquire a 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. The 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.
Factoring is an arrangement whereby a business sells all or selected accounts payables to a third party at a price lower than the realizable value of those accounts. The third party here is known as the ‘factor’ who provides factoring services to businesses. The factor would not only provide financing by purchasing the accounts but also collects the amount from the debtors. Factoring is of two types – with recourse and without recourse. The credit risk of nonpayment by the debtor is borne by the business in the case of with recourse, and it is borne by the factor in the case of without recourse.
Some other sources of working capital financing used are inter-corporate deposits, commercial paper, public deposits, etc.
Quiz on Working Capital Financing
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