11. WORKING CAPITAL FINANCING
The need for financing arises in working capital because of investment in current assets and current liabilities. Working capital requirements/ current assets are finance by a combination of long term and short-term sources. The important tradition of short-term sources of current assets financing are trade credit and bank credits. The two newly emerged sources of working capital are factoring and commercial papers.
1) Trade credit:
Trade credit refers to the credit that a customer gets from suppliers of goods and services in the normal course of business/ sale / transaction of the firm. In practice, cash is not paid immediately for purchases but after an agreed period of time. Thus the deferral of payment is a major source of finance for credit purchases.
The features of trade credit are as follows as:
1. It is an informal arrangement between the buyer and seller.
2. There are no legal instruments / acknowledgement of debt which are granted on an open basis. Such a credit appears in the records of the buyer of goods as sundry creditors / accounts payable.
Trade credit may also in the form of bills payable. When the buyer signs a bill – a negotiable instrument – to obtain a credit, it appears on the buyer’s balance sheet as bills payable. The bill has a specified feature date, and is, usually used when the supplier is less sure about the buyer’s willingness and ability to pay, or when the supplier wants to pay, or when the supplier wants the cash by discounting the bill from a bank. A bill is a formal acknowledgement of an obligation to repay the outstanding amount.
The advantages of trade credit are as follows: -
1) Easy Availability:
It is very easy to obtain and also almost automatic and doesn’t require negotiations. The easy availability is particularly important to small firms, which generally face difficulty in raising funds from the capital market.
2) Flexibility:
Flexibility is another advantage of trade credit. Trade credit grows with the growth in firm’s sales. The expansion in the firm’s sales causes its purchases of goods and services to increase, which is automatically financed by trade credit.
3) Informality:
Trade credit is an informal, negotiations and formal agreement. It doesn’t have the restrictions, which are usually parts of negotiated source of finance.
2) COMMERCIAL PAPERS:
Commercial papers are negotiable short-term unsecured promissory notes with fixed maturities, issued by well rated companies generally sold on discount basis. Companies can issue commercial papers either directly to the investors or through banks / merchant banks (called dealers). These are basically instruments evidencing the liability of the issuer to pay the holder in due course a fixed amount (face value of the instrument) on the specified due date. These are issued for a fixed period of time at a discount to the face value and mature at par.
These instruments are normally issued in the multiples of five crores for 30/45/60/90/120/180/270/364 days.
Two key regulations govern the issuance of commercial papers- firstly Commercial
papers- firstly commercial papers have to be compulsorily rated by a recognized
credit rating agency and only companies can issue commercial papers which have a
short term rating of at least P1/A1. Secondly, funds raised through commercial
papers do not represent fresh borrowings for the corporate issuer but merely
substitute a part of the banking limits available to it. Hence a company issues
commercial papers mostly to save on interest costs i.e. it will issue commercial
papers only when the environment is such that commercial papers issuance will be
at rates lower the rate at which it borrows money from it's banking consortium.
Issuance of a commercial paper on a regular basis would be used as a good line
of credit. It also works as a good tool for liability management. As the lenders
in this market are predominantly banks, call markets affect commercial paper
rate; lower call rates mean cash surplus banks will view commercial papers as an
alternate investment route. Higher call rate also discourage corporate form
issuing commercial papers as it means higher cost of funds.
Ideally, the discount rates on commercial papers ought to be determined by the
demand and supply factors in the money market and the interest rates on the
other hand competing money market instruments such as certificate of deposits
(CDs), commercial bills and treasury bills. It has been noticed that in a
comparatively stable and low rate conditions in the money market, the discount
rates in the commercial paper markets do somewhat soften whereas in the tight
money market situation it may not be possible even for a best rated company to
issue commercial papers at lower rates than the lending rates on it's banks
lines of credit. This is partly for the reason that banks could also firm up the
lending rates during such periods. The maturity management of commercial papers
should also affect the commercial paper rates. It has been observed that in a
period of prolong low and steady money market rates there is no significant
different between the discount rates if commercial papers for 90 and 180 days.
However, in the situated of rising money market rates the difference in discount
rates for 90 days and 180 days is expected to widen.
Advantage Of Commercial Papers
The advantage of commercial paper lies in its simplicity involving less paper
work as large amounts can be raised without having any underlying transaction.
It gives flexibility to the company by providing an additional option of raising
funds particularly when the conditions prevailing in the money market are
favorable. In a regime where there is a prescription of a minimum lending rate
for banks advances, the raising of funds by a company upto 75% of its working
capital limit through issue of commercial papers at somewhat lower interest
rates, enables it to reduce the overall cost of short-term funds. It is,
however, to be recognized that under the cash credit system of lendings, the
borrowers' effective interest cost is lower than the prescribed lending rate as
this system affords flexibility to borrowers to reduce the outstandings as and
when surplus funds accrue to them. Hence, a company proposing to issue
commercial papers should have a clear perception as to its cash flow during the
period for which commercial papers are proposed to be issued and accordingly fix
the discount rates at which the instrument is to be issued.
In a situation of following money market rates, the issuing companies can take
the immediate advantage of lower interest rate vis a vis the interest rates on
their cash credit limit as it takes comparatively longer time for the monetary
authority to bring about a proper alignment of bank's lending rates with the
overall movements in interest rates due to administrative lag. The company
accessing the city market would command prestige, which has a positive effect on
its relations with banks and the placements of long-term debt. In the financial
markets of developed countries, the degree of access to domestic commercial
paper market is viewed as a key factor for acceptance of such issues in the
international market. Thus, there is an inbuilt need for companies to remain
financially strong.
From the investor's point of view, the investment in commercial papers gives
comparatively higher yields than those obtained on bank deposits of similar
maturities. Although commercial paper is an unsecured promissory note, the
availability of stand-by facility by banks to the issuing companies makes it's
holders confident of getting the payment on due dates. This agreement also
facilitated quicker payment as a company's banker and make the payment to the
holders on their behalf and as the companies permissible working capital limit
gets reinstated to the extent of maturing commercial papers provided, however,
at the time of maturity of commercial papers, the companies maximum permissible
bank finance has not been revised downwards.
3) FACTORING:
Factoring is essentially a management (financial) service designed to help firms better manage their receivables; it is, in fact, a way of offloading a firm's receivables and credit management on to some one else - in this case, the factoring agency or the factor. Factoring involves an outright sale of the receivables of a firm by another firm specializing in the management of trade credit, called the factor. Under a typical factoring arrangement a factor collects the accounts on the due dates, effects payments to its client firm on these days (irrespective of whether or not it has received payment or not) and also assumes the credit risks associated with the collection of the accounts. For rendering these services, the factor charges a fee, which is usually expressed as a percentage of the total value of the receivables, factored. Factoring is thus an alternative to in-house management of receivables. The complete package of factoring services includes (1) sales ledger administration; (2) finance; and (3) risks control.
Sales ledger administration: For a service fee, the factor provides its client firm professional expertise in accounting and maintenance of sales ledger and for collection of receivables.
Finance: The factor advances up to a reasonable percentage of outstanding receivables that have been purchased, say, about 80 percent immediately, and the balance minus commission on maturity. Thus, the factor acts as a source of short-term funds.
Risk Control: The factor having developed a high level of expertise in credit appraisal reduces the risk of loss through bad debts.
Depending upon the inherent requirements of the clients, the terms of factoring contract vary, but broadly speaking, factoring service can be classified as :
(a) Non-recourse factoring; and
(b) recourse factoring.
In non-recourse factoring, the factor assumes the risk of the debts going "bad". The factor cannot call upon its client-firm whose debts it has purchased to make good the loss in case of default in payment due to financial distress. However, the factor can insist on payment from its client if a part of the receivables turns bad for any reason other than financial insolvency.
In recourse factoring, the factoring firm can insist upon the firm whose receivables were purchased to make good any of the receivables that prove to be bad and unrealizable. However, the risks of bad debts are not transferred to the factor.
Legal Aspects
The legal status of a factor is that of an assignee. Once the factor purchases the receivables of a firm and this fact is notified to the customers, they are under a legal obligation to make all remittances to the factor' A customer who by mistake remits the payments to the firm is not discharged from his obligations to the factor until and unless the firm remits the proceeds to the factor. The factoring agreement governs the legal relationship between a factor and the firm whose receivables are to be factored, and is so drawn as to suit the various needs specifying the period of validity of the contract and modalities of termination.
Financial Aspects
Factoring involves two types of costs: (a) factoring commission; and (b) interest on funds advances.
Factoring commission represents the compensation to the factor for the administrative services provided and the credit risk borne. The commission charged is usually 2-4 per cent of the face value of the receivables factored, the rate depending upon the various forms of service and whether it is with or without recourse.
The factor also charges interest on advances drawn by the firm against uncollected and non-due receivables. In the Ul(, it is the practice to advance up to 80 per cent of the value of such outstanding at a rate of interest which is 2-4 per cent above the base rate. This works out to near the interest rate for bank overdrafts.
The cost of factoring varies, from 15.2 to 16.20 per cent (Singh, 1988), 15.6 to 16.0 percent (SBI Monthly Review, 1989), and the margins in which the factors will have to operate would be extremely narrow. The strategy of factors, therefore, must be to carve out a niche in the services segment namely, receivables management and generate revenues by way of commission rather than concentrate on lending and financing activities where the margins are low.
Factoring offers the following advantages from the firm's point of view:
Advantages
1. Firms resorting to factoring also have the added attraction of ready source of short-term funds. This form of finance improves the cash flow and is invaluable as it leads to a higher level of activity resulting in increased profitability.
2. By offloading the sales accounting and administration, the management has more time for planning, running and improving the business, and exploiting opportunities, The reduction in overheads brought about by the factor's administration of the sales ledger and the improved cash flows because of the quicker payments by the customers result in interest savings and contribute towards cost savings.
Disadvantages
1. Factoring could prove to be costlier to in-house management of receivables, especially for large firms which have access to similar sources of funds as the factors themselves and which on account of their size have well-organized credit and receivable management.
2. Factoring is perceived as an expensive form of financing and also as finance of the last resort. This tends to have a deleterious effect on the creditworthiness of the company in the market.
4) BANK CREDIT:
Bank credit is the primary institutional source of working capital finance in India. There are five ways of working capital finance by banks. They are as follows:
a. Cash credit / overdraft:
Under this form, the bank specifies a predetermined borrowing / credit limit. The borrower can drew / borrow up to the stimulated period of the overdraft limit. Within the specified limit, any number of drawls/drawings are possible to the extend of the requirements periodically. Similarly, repayments can be made whenever desired during the period. The interest is determined on the basis of the running balance actually utilized by the borrower and not on the sanctioned life.
b. Loans:
In this form of finance, the entire amount of borrowing is credited to the capital account of the borrower or released in cash. The borrower has to pay the interest on the total amount. The loans are repayable on demand or in periodic installments. They can be renewed as per the situation.
c. Term loans for working capital :
Under this system, bank advances the loan for the period of 3-7 years repayable in yearly or half-yearly installments.
d. Letter of Credit:
It is an indirect form of working capital financing and banks assume only the risk, credit being provided by the supplier himself. The purchaser of goods on credit obtains a letter of credit from a bank. The bank takes the responsibilities to make the payment to the credit in case the buyer fails to meet his obligations. Thus the modus operandi of letter of credit is that the supplier sells goods on credit/extends credit to the purchaser, the bank gives a guarantee and bears risk only in case of default by the purchaser.
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