Wcm unit 5

Mechanism and Cost-Benefit Analysis Of Alternative

Strategies For Financing Working Capital: Accrued Wages
And Taxes, Accounts Payable, Trade Credit, Bank Loans,
Overdrafts, Bill Discounting, Commercial Papers,
Certificates Of Deposit, Factoring, Secured Term Loans, etc.
 
Accrued Wages And Taxes
Accrued wages refers to the amount of liability remaining at the end of a reporting period for
wages that have been earned by hourly employees but not yet paid to them. This liability is
included in the current liabilities section of the balance sheet of a business. Accrued wages are
recorded in order to recognize the entire wage expense that a business has incurred during a
reporting period, not just the amount actually paid.

For example, Mr. Smith is paid $20 per hour. He is paid through the 25th day of the month, and
has worked an additional 32 hours during the 26th through 30th days of the month. This unpaid
amount is $640, which the employer should record as accrued wages as of month-end. This
accrual may be accompanied by an additional entry to accrue for any related payroll taxes.

The accrued wages entry is a debit to the wages expense account, and a credit to the accrued
wages account. The entry should be reversed at the beginning of the following reporting period.

Accounts Payable
The accounts payable process or function is immensely important since it involves nearly all of a
company’s payments outside of payroll. The accounts payable process might be carried out by an
accounts payable department in a large corporation, by a small staff in a medium-sized company,
or by a bookkeeper or perhaps the owner in a small business.

Regardless of the company’s size, the mission of accounts payable is to pay only the company’s
bills and invoices that are legitimate and accurate. This means that before a vendor’s invoice
is entered into the accounting records and scheduled for payment, the invoice must reflect:

 what the company had ordered

 what the company has received
 the proper unit costs, calculations, totals, terms, etc.

To safeguard a company’s cash and other assets, the accounts payable process should
have internal controls. A few reasons for internal controls are to:
 prevent paying a fraudulent invoice
 prevent paying an inaccurate invoice
 prevent paying a vendor invoice twice
 be certain that all vendor invoices are accounted for

Periodically companies should seek professional assistance to improve its internal controls.

The accounts payable process must also be efficient and accurate in order for the company’s
financial statements to be accurate and complete. Because of double-entry accounting an
omission of a vendor invoice will actually cause two accounts to report incorrect amounts. For
example, if a repair expense is not recorded in a timely manner:

1. The liability will be omitted from the balance sheet, and

2. The repair expense will be omitted from the income statement.

If the vendor invoice for a repair is recorded twice, there will be two problems as well:

1. The liabilities will be overstated, and

2. Repairs expense will be overstated.

In other words, without the accounts payable process being up-to-date and well run, the
company’s management and other users of the financial statements will be receiving inaccurate
feedback on the company’s performance and financial position.

A poorly run accounts payable process can also mean missing a discount for paying some bills
early. If vendor invoices are not paid when they become due, supplier relationships could be
strained. This may lead to some vendors demanding cash on delivery. If that were to occur it
could have extreme consequences for a cash-strapped company.

Just as delays in paying bills can cause problems, so could paying bills too soon. If vendor
invoices are paid earlier than necessary, there may not be cash available to pay some other bills
by their due dates.

Trade Credit
Trade credit is an important external source of working capital financing. It is a short-term credit
extended by suppliers of goods and services in the normal course of business, to a buyer in order
to enhance sales. Trade credit arises when a supplier of goods or services allows customers to
pay for goods and services at a later date. Cash is not immediately paid and deferral of payment
represents a source of finance.

Features of Trade Credit:

1. There are no formal legal instruments/acknowledgements of debt.

2. It is an internal arrangement between the buyer and seller.
3. It is a spontaneous source of financing.
4. It is an expensive source of finance, if payment is not made within the discount period.

Advantages of Trade Credit:

1. It is easy and automatic source of short-term finance.

2. It reduces the capital requirement.
3. It helps the business focus on core activities.
4. It does not require any negotiation or formal agreement.

Disadvantages of Trade Credit:

Like other sources of finance, trade credit is also associated with certain disadvantages,
which are as follows:

1. Trade credit is available only to those companies that have a good track record of
repayment in the past.
2. For a new business, it is very difficult to finance working capital through trade credit.
3. It is very expensive, if payment is not made on the due date.

Bank Loans
Working capital loans are as good as term loan for a short period. These loans may be repaid in
installments or a lump sum at the end. The borrower should take such loans for financing
permanent working capital needs. The cost of interest would not allow using such loans for
temporary working capital.

Overdrafts
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 which 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 cost. Without a doubt, this is a cost-effective working capital financing.

Bill Discounting
Invoice discounting can be technically defined as the selling of bill to invoice discounting
company before the due date of payment at a value which is less than the invoice amount. The
difference between the bill amount and the amount paid is the fee of the invoice discounting to
the company. The fee will depend on the period left before payment date, amount and the
perceived risk.
 The bills or invoices under bill discounting are legally the ‘bill of exchange’. A bill of exchange
is a negotiable instrument which is negotiable mere by endorsing the name. For example our
currency is an example of bill of exchange. Currency provides value written over it to the bearer
of the instrument. In the case of bill discounting, such bills can be either payable to the bearer or
payable to order. Therefore, after discounting a bill, a bank can further get the bill discounted
from other banks in case of cash flow requirement.

Commercial Papers
Commercial paper is an unsecured, short-term debt instrument issued by a corporation, typically
for the financing of accounts receivable, inventories and meeting short-term liabilities.
Commercial paper is usually issued at a discount from face value and reflects prevailing market
interest rates.

Commercial paper is an unsecured and discounted promissory note issued to finance the short-
term credit needs of large institutional buyers.

Features of Commercial Paper:-

1. The maturity period of commercial paper lies between 15 days to less than 1 year.
2. It is sold at a discount but redeemed at its par value.
3. There is no well-developed secondary market for commercial paper; rather they are
placed with existing investors who intend to hold it till it gets matured.

Commercial Papers have a variety of benefits to both, the issuer as well as the investor.

There are a few important things to note about Commercial Papers, such as their rules,
conditions and requirements.

Certificates Of Deposit
Certificate of Deposit (CD) implies an unsecured, money market negotiable instrument, issued
by the commercial bank or financial institution, either in demat form or as a usance promissory
note, at a discount to face value at market rates, against the amount deposited by an individual,
for a stipulated time.

In finer terms, certificate of deposit is a fixed interest bearing term deposit, which has a fixed
maturity. It limits the access to the funds, until the lock-in period of the investment, i.e. the
depositor cannot withdraw funds, on demand.

Salient Features of Certificate of Deposit

 Eligibility: All scheduled commercial bank, not including regional rural bank and
cooperative bank, are eligible to issue the certificate of deposit. It can be issued by the bank to
 individuals, companies, trust, funds, associations, etc. On the non-repatriable basis, it can be
issued to Non-Resident Indians (NRIs) also.
 Maturity period: The CDs are issued by the bank at a discount to face value, at market-
related rates, ranging from 3 months to one year. When a financial institution issues CD, the
minimum term is one year and maximum three years. In addition to this, no grace period is
allowed for the repayment of CD.
 Denomination: The minimum issue size of a certificate of deposit is Rs. 5,00,000 to a
single investor. Moreover, when the certificate of deposit exceeds Rs. 5,00,000, it should be in
multiples of Rs. 1,00,000. Add to that; there is no ceiling on the total amount of funds raised
through it.
 Transferability: Certificate of deposit existing in physical form can be freely transferred
by way of endorsement and delivery. CDs in dematerialised form can be transferred, as per the
process of other dematerialised securities.
 Reserve requirement: Banks are required to keep CRR and SLR on the issue price of
the certificate of deposit.
 Format: Banks and financial institutions can issue CD in dematerialised form only.
Although the investor, at their discretion, can seek a certificate in traditional form. Moreover, it
attracts stamp duty.
 Discount: Certificate of Deposit is issued at a discount to face value, determined by the
market, which can be front end or rear end discount. The effective rate of discount is greater than
the quoted rate in case of front end discount. On the contrary, in rear end discount, the CDs yield
the quoted rate on the expiry of the specified term.

Banks issue certificate of deposit when the deposit growth is comparatively slow, and credit
demand is high, and there is a tightening trend in the call rate. These are high-cost liabilities, and
banks take recourse of CD’s only when there exist stiff liquidity conditions in the market.

Factoring
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 business. 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 case of with recourse and it is borne by the factor in the case of
without recourse.

Secured Term Loans

A secured term loan is a loan granted to the business where the borrower then pledges some form
of security or collateral against the loan. Our lenders look at either property (commercial or
residential) or a debtors book as security against a loan. This means that your business cash flow
and profitability is not as important as the underlying security offered to the lender.  Because
there is security, the risk is lower than an unsecured loan and so the interest rates charged by the
lender are normally lower than an unsecured loan.  Secured loans are normally short medium
term loans ranging from 6 months to 5 years.