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 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 the 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.

List of spontaneous sources of working capital

Trade Credit

Sundry Creditors

Bills Payable

Notes Payable

Accrued Expenses

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

Tax Provisions

Dividend Provisions

Short-term External Sources

Short-term working capital financing from banks such as

Bank Overdrafts,

Cash Credits,

Trade Deposits,

Bills Discounting,

Short-term Loans or Working Capital 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 prove 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.

Long-term Internal Sources

Retained Profits

Provision for Depreciation

Long-term External Sources

Share Capital

Long-term Loan

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 as 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.