Chapter 21

SOURCES OF WORKING
CAPITAL
 LEARNING OBJECTIVES
• Name two major sources to working capital.
• List the sources of short term working capital.
• Explain the benefits and costs of trade credit.
• Narrate the features of commercial paper.
• Discuss the different modes of bank finance for working capital.
• Explain the different modes of security required by banks for operating credit.
• Discuss different types of letter of credit.
• Give the meaning of Factoring and list its features.
• Explain the mechanics of factoring.
• Discuss the costs and benefits of factoring.
• Discuss the long-term sources of working capital finance
 Sources of Working Capital

Trade Credit

Accruals

Deferred Income
Sources of Commercial Paper
Working Capital
Finance Public Deposit

Inter-Corporate Deposit

Commercial Banks

Factoring
 Commercial Papers (CPs)
CP: A short-term unsecured promissory note issued by firm with
highly credit rating
Features
– The maturity period of CP ranges from 15 to 365 day (but in
India it ranges between 91 to 180 days).
– It is sold at a discount from its face value and redeemed at its
face value.
– Return on CP is the difference between par value and
redeemable value.
– It may be sold directly to investors or indirectly through dealers.
– There is no developed secondary market for CP.
 Eligibility to Issue CPs

• Latest tangible networth should be not less than Rs.5 crore

• Company should be eligible to sanction fund based bank
finance
• Can be issued CPs for 75% of bank credit
• Minimum credit rating should be: P2 from CRISL A-2 from
ICRA
• Minimum size of each CP Rs.5 lakhs
• Issue size should not be less than one crore
 Evaluation of CPs
Advantages
• Alternative source of finance during the period of tight bank
credit
• Cheaper source when compared to bank credit

Disadvantages
• Available only for large and financially sound companies
• Can not be redeemed before maturity date
 Public Deposits [Regulations]
• Public deposits can not be issued more than 25% of share capital
and free resources
• Can be issued for a period ranging from 6 months to 3 years
period
• Maximum period is 5 years for NBFCs
• Need to set aside 10% of maturity value of public deposit every
year by 31st March
• Need to disclose relevant, true, fair, vital facts of financial
performance
 Evaluation of Public Deposits
Advantages
• Simple procedure
• No restrictive covenants
• No security offered
• Cheaper source
Disadvantages
• Limited funds can be raised
• Only for short-period
 Inter-corporate Deposits
Types
– Call Deposits
– Three months deposits
– Six months deposits
Features
– No legal regulations
– Given and taken in secrecy
– Available on personal contacts
 Forms of Bank Finance
• Loans
• Overdrafts
• Cash credit
• Bills discounting
• Bills purchase
• Letter of credit (L/C)
Security Required in Bank Finance
• Hypothecation
• Pledge
• Mortgage
 Factoring
• Factor: A financial institution which render services relating to
the management and financing of debtors.
• Factor selects accounts receivables of their client
• Factor takes responsibility of collecting accounts receivables
selected by it
 Mechanics of Factoring
Factor

5
Pay-
ment
upto
80%
6
4 Monthly
Sends Statement
Invoice
Copy
7 Follow
Up

9 8
2 Fixes Pays Balance
Credit Pays Balance
amount amount
Limit (20%) (20%)

Client (Seller) 3 Sends Goods and Invoice Customer

(Buyer)
1 Places Order
 Types of Factoring
Recourse Factoring

Non-Recourse Factoring

Modified Recourse Factoring

Undisclosed Factoring

Notified Factoring
Types of
Factoring
Bulk Factoring

Domestic Factoring

International Factoring

Export Factoring

Import Factoring
 Benefits of Factoring [for Company]
• Ready cash
• Substantial funds up to 80% of invoices
• Able to offer competitive terms to buyers
• Liquidity will improve
• Simple appraisal and documentation procedure
• Provides much more than bills discounting
• Available will liberal grace periods
• Minimum security formalities
• Replaces high cost of market credit
• Saves time
 Benefits of Factoring
For Buyer
• Facilitates credit purchases
• Saving on high bank charges
• No documentation except acknowledgement of the letter of
credit
• Receive periodical statements of outstanding invoices

For Banker
• Improves liquidity of bank customer
• Complementary product to bank customer
• Credit sales are closely monitored
• Improves quality of advances of banks
 Factoring Problems
• A cheap service can prove expensive
• Involves hidden charges
• Some factors are strict and provide restrictive service
• Low credit limits
• Minimum charges
• Key customer funding restrictions
• Same day payment fees
• Clearing days vary
• Quality of on-line services