Working Capital: 8 Sources of Working Capital Finance – Explained!

The two segments of working capital viz., regular or fixed or permanent and variable are financed by the long-term and the short-term sources of funds respectively. The main sources of long-term funds are shares, debentures, term- loans, retained earnings etc.

The sources of short-term funds used for financing variable part of working capital mainly include the following:

1. Loans from commercial banks

2. Public deposits

3. Trade credit

4. Factoring

5. Discounting bills of exchange

6. Bank overdraft and cash credit

7. Advances from customers

8. Accrual accounts

These are discussed in turn.

1. Loans from Commercial Banks:

Small-scale enterprises can raise loans from the commercial banks with or without security. This method of financing does not require any legal formality except that of creating a mortgage on the assets. Loan can be paid in lump sum or in parts. The short-term loans can also be obtained from banks on the personal security of the directors of a country.

Such loans are known as clean advances. Bank finance is made available to small- scale enterprises at concessional rate of interest. Hence, it is generally a cheaper source of financing working capital requirements of enterprise. However, this method of raising funds for working capital is a time-consuming process.

2. Public Deposits:

Often companies find it easy and convenient to raise short- term funds by inviting shareholders, employees and the general public to deposit their savings with the company. It is a simple method of raising funds from public for which the company has only to advertise and inform the public that it is authorised by the Companies Act 1956, to accept public deposits.

Public deposits can be invited by offering a higher rate of interest than the interest allowed on bank deposits. However, the companies can raise funds through public deposits subject to a maximum of 25% of their paid up capital and free reserves.

But, the small-scale enterprises are exempted from the restrictions of the maximum limit of public deposits if they satisfy the following conditions:

The amount of deposit does not exceed Rs. 8 lakhs or the amount of paid up capital whichever is less.

(i) The paid up capital does not exceed Rs. 12 lakhs.

(ii) The number of depositors is not more than 50%.

(iii) There is no invitation to the public for deposits.

The main merit of this source of raising funds is that it is simple as well as cheaper. But, the biggest disadvantage associated with this source is that it is not available to the entrepreneurs during depression and financial stringency.

3. Trade Credit:

Just as the companies sell goods on credit, they also buy raw materials, components and other goods on credit from their suppliers. Thus, outstanding amounts payable to the suppliers i.e., trade creditors for credit purchases are regarded as sources of finance. Generally, suppliers grant credit to their clients for a period of 3 to 6 months.

Thus, they provide, in a way, short- term finance to the purchasing company. As a matter of fact, availability of this type of finance largely depends upon the volume of business. More the volume of business more will be the availability of this type of finance and vice versa.

Yes, the volume of trade credit available also depends upon the reputation of the buyer company, its financial position, degree of competition in the market, etc. However, availing of trade credit involves loss of cash discount which could be earned if payments were made within 7 to 10 days from the date of purchase of goods. This loss of cash discount is regarded as implicit cost of trade credit.

4. Factoring:

Factoring is a financial service designed to help firms in managing their book debts and receivables in a better manner. The book debts and receivables are assigned to a bank called the ‘factor’ and cash is realised in advance from the bank. For rendering these services, the fee or commission charged is usually a percentage of the value of the book debts/receivables factored.

This is a method of raising short-term capital and known as ‘factoring’. On the one hand, it helps the supplier companies to secure finance against their book debts and receivables, and on the other, it also helps in saving the effort of collecting the book debts.

The disadvantage of factoring is that customers who are really in genuine difficulty do not get the opportunity of delaying payment which they might have otherwise got from the supplier company.

In the present context where industrial sickness is spreading like an epidemic, the reason for which particularly in SSI sector being delayed payments from their suppliers; there is a clear-cut rationale for introduction of factoring system. There has been some progress also on this front.

The recommendations of the Study Group (RBI 1996) to examine the feasibility of setting up of factoring organisations in the country, under the Chairmanship of Shri C. S. Kalyanasundaram have been accepted by the Government of India. The Group is of the view that factoring for SSI units could prove to be mutually beneficial to both Factors and SSI units and Factors should make every effort to orient their strategy to crystallize the potential demand from the sector.

5. Discounting Bills of Exchange:

When goods are sold on credit, bills of exchange are generally drawn for acceptance by the buyers of goods. The bills are generally drawn for a period of 3 to 6 months. In practice, the writer of the bill, instead of holding the bill till the date of maturity, prefers to discount them with commercial banks on payment of a charge known as discount.

The term ‘discounting of bills’ is used in case of time bills whereas the term, ‘purchasing of bills’ is used in respect of demand bills. The rate of discount to be charged by the bank is prescribed by the Reserve Bank of India (RBI) from time to time. It generally amounts to the interest for the period from the date of discounting to the date of maturity of bills.

If a bill is dishonoured on maturity, the bank returns the dishonoured bill to the company who then becomes liable to pay the amount to the bank. The cost of raising finance by this method is the amount of discount charged by the bank. This method is widely used by companies for raising short-term finance.

6. Bank Overdraft and Cash Credit:

Overdraft is a facility extended by the banks to their current account holders for a short-period generally a week. A current account holder is allowed to withdraw from its current deposit account upto a certain limit over the balance with the bank. The interest is charged only on the amount actually overdrawn. The overdraft facility is also granted against securities.

Cash credit is an arrangement whereby the commercial banks allow borrowing money up to a specified-limit known as ‘cash credit limit.’ The cash credit facility is allowed against the security. The cash credit limit can be revised from time to time according to the value of securities. The money so drawn can be repaid as and when possible.

The interest is charged on the actual amount drawn during the period rather on limit sanctioned. The rate of interest charged on both overdraft and cash credit is relatively higher than the rate of interest given on bank deposits. Arranging overdraft and cash credit with the commercial banks has become a common method adopted by companies for meeting their short- term financial, or say, working capital requirements.

7. Advances from Customers:

One way of raising funds for short-term requirement is to demand for advance from one’s own customers. Examples of advances from the customers are advance paid at the time of booking a car, a telephone connection, a flat, etc. This has become an increasingly popular source of short-term finance among the small business enterprises mainly due to two reasons.

First, the enterprises do not pay any interest on advances from their customers. Second, if any company pays interest on advances, that too at a nominal rate. Thus, advances from customers become one of the cheapest sources of raising funds for meeting working capital requirements of companies.

8. Accrual Accounts:

Generally, there is a certain amount of time gap between incomes is earned and is actually received or expenditure becomes due and is actually paid. Salaries, wages and taxes, for example, become due at the end of the month but are usually paid in the first week of the next month. Thus, the outstanding salaries and wages as expenses for a week help the enterprise in meeting their working capital requirements. This source of raising funds does not involve any cost.