Working Capital Financing

 Trade credit
 Bank Credit
 Commercial Papers
 Certificate of Deposits
 Factoring

A) Trade Credit Trade credit is the credit extended by one trader to another for the
purchase of goods and services. It facilitates the purchase of supplies without immediate
payment and is commonly used by business organizations as a source of short-term
financing.

Understanding Trade Credit

Trade credit is usually offered for 7, 30, 60, 90 or 120 days but a few businesses such as
goldsmiths and jewelers may extend credit beyond the period. The terms of the sale
mention the period for which credit is granted, along with any cash discount and the type
of credit instrument being used.

For example, a customer is granted credit with terms of 4/10, net 30. It means that the
customer has 30 days from the invoice date within which to pay the seller. In addition, a
cash discount of 4% from the stated sales price is to be given to the customer if payment
is made within 10 days of invoicing. If instead, the terms of sale were net 7, then the
customer would have 7 days from invoice date to pay with no discount offered for early
payment.

Trade credit extended to a customer by a firm appears as accounts receivable and trade
credit extended to a firm by its suppliers appears as accounts payable. Trade credit can
also be thought of as a form of short-term debt which doesn’t have any interest associated
with it.
Credit Period

Credit periods vary among different industries. For example, a jewelry store may sell diamond
engagement rings for 5/30, net 4 months. A food wholesaler, selling fresh fruit and produce, may
use net 7. Generally, a firm must consider three factors in setting a credit period:

1. The probability that the customer will not pay – A firm whose customers are in high-risk
businesses may find itself offering restrictive credit terms.
2. The size of the account – If the account is small, the credit period will be shorter. Small
accounts are more costly to manage.
3. The extent to which the goods are perishable – If the collateral values of the goods are
low and cannot be sustained for long periods, less credit will be granted.

Lengthening the credit period effectively reduces the price paid by the customer. Generally, this
increases sales. Cash flows as a result of trade credit being granted are shown below

B) Bank Credit
Bank credit is the total amount of credit available to a business or individual from
a banking institution. It consists of the total amount of combined funds that financial institutions
provide to an individual or business.

Credit approval is determined by a borrower's credit rating, income, collateral, assets, and pre-
existing debt.
There are two main forms of private credit created by banks; unsecured (non-collateralized)
credit such as consumer credit cards and small unsecured loans, and secured (collateralized)
credit, typically secured against the item being purchased with the money (house, boat, car, etc.).
To reduce their exposure to the risk of not getting their money back (credit default), banks will
tend to issue large credit sums to those deemed credit-worthy, and also to require collateral;
something of equivalent value to the loan, which will be passed to the bank if the debtor fails to
meet the repayment terms of the loan. In this instance, the bank uses sale of the collateral to
reduce its liabilities. Examples of secured credit include consumer mortgages used to buy
houses, boats etc., and PCP (personal contract plan) credit agreements for automobile purchases.
 C) Commercial Papers
Commercial Paper (CP) is an unsecured money market instrument issued in the form of a
promissory note.

Companies, including Non-Banking Finance Companies (NBFCs) and All India Financial
Institutions (AIFIs), are eligible to issue CPs subject to the condition that any fund-based facility
availed of from bank(s) and/or financial institutions is classified as a standard asset by all financing
banks/institutions at the time of issue.

Other entities like co-operative societies/unions, government entities, trusts, limited liability
partnerships and any other body corporate having presence in India with a net worth of ₹100 crore
or higher subject to the condition as specified under (a) above.

Any other entity specifically permitted by the Reserve Bank of India (RBI).All residents, and non-
residents permitted to invest in CPs under Foreign Exchange Management Act (FEMA), 1999 are
eligible to invest in CPs; however, no person can invest in CPs issued by related parties either in
the primary or secondary market. Investment by regulated financial sector entities will be subject
to such conditions as the concerned regulator may impose.CP can be issued for maturities between
a minimum of 7 days and a maximum of up to one year from the date of issue. However, the
maturity date of the CP should not go beyond the date up to which the credit rating of the issuer is
valid. CP can be issued in denominations of Rs.5 lakh or multiples thereof. CP is issued at a
discount to face value as may be determined by the issuer.

D) Certificates of Deposit

The Certificate of Deposit (CD) is an agreement between the depositor and the bank where a
predetermined amount of money is fixed for a period and the bank pays interest on it. It is a
money market instrument issued against some funds for a specific tenure, a promissory note by
the bank and insured by the Federal Deposit Insurance Corporation (FDIC).

The Reserve Bank of India (RBI) issues guidelines for the CD from time to time. The Certificate
of Deposit is issued in dematerialised form i.e. issued electronically and may automatically be
renewed if the depositor fails to decide what to do with the matured amount during the grace
period of 7 days. It also restricts the holder from withdrawing the amount on demand or pay a
penalty, otherwise. When the Certificate of Deposit matures, the principal amount along with the
interest earned is available for withdrawal.

The following are the salient features of the Certificate of Deposit:

 Eligibility: Only scheduled commercial banks/financial institutions in India (allowed by

RBI) can issue Certificates of Deposit. Co-operative banks and Regional Rural Banks
cannot issue these certificates. These can only be issued to individuals, companies, funds,
etc. It can be issued to Non-Residential Indians (NRIs) on non-repatriable basis.
  Maturity Period: A Certificate of Deposit issued by the commercial banks can have
maturity period ranging from 7 days to 1 year. For financial institutions, it ranges is from
1 year to 3 years. Minimum amount to be deposited is Rs. 1 Lakh.
 Transferability: Certificates which are available in demat forms must be transferred
according to the guidelines followed by demat securities. While dematerialised/electronic
certificates can be transferred by endorsement or delivery.

 Availability of Loan: Since these instruments do not have any lock-in period, banks do
not grant loans against them. In fact, banks cannot even buy back certificates of deposit
before maturity. They will have to first consider the Statutory Liquidity Ratio (SLR) and
Cash Reserve Ratio (CRR) on the issued Certificate of Deposit Rates or

Advantages
 Fund or the principal amount is safe with
Certificates of Deposit. Hence, they are less
risky than stocks, bonds and other volatile
instruments
 The Certificate of Deposit offers a higher rate
of interest and better returns as compared to
traditional savings accounts
 The grace period of 7 days is granted to decide
the future investment of the matured amount
Disadvantages
 The invested amount is parked for the preferred
duration and withdrawal of the amount is only
possible by paying a penalty. Hence, it has limited
liquidity
 CD interest rates are renewed by banks if one fails
to decide what to do with the matured amount and
the new interest rate might be lesser than other
investment options
 Interest rates on CD are not tied to the rate of
inflation and hence the value of money may
decrease with increasing inflation

E) Factoring
Factoring implies a financial arrangement between the factor and client, in which the firm
(client) gets advances in return for receivables, from a financial institution (factor). It is a
financing technique, in which there is an outright selling of trade debts by a firm to a third
party, i.e. factor, at discounted prices.

Factoring is a financial alternative, in financing and management of account receivables. It states

the terms and conditions of the sale in the factoring agreement.

In finer terms factoring is a relationship between the factor and the client, in which the factor
purchases the client’s account receivables and pay up to 80% (sometimes 90%) of the sum
immediately, at the time of entering into the agreement. The factor pays the balance sum, i.e.
20% of the amount which includes finance cost and operating cost, to the client when the
customer pays the obligation. Procedure is as follows:
1. Borrowing company or the client sells the book debts to the lending institution (factor).
2. Factor acquires the receivables and extend money against the receivables, after deducting and
retaining the following sum, i.e. an adequate margin, factor’s commission and interest on
advance
3. Collection from the customer is forwarded by the client to the factor and in this way, the advance
is settled.
4. Other services are also provided by the factor which includes:
 Finance
 Collection of debts
 Maintenance of debts
 Protection of Credit Risk
 Maintenance of debtors ledger
 Debtors follow-up
 Advisory services
The factor gets control over the client’s debtors, to whom the goods are sold on credit or credit is
extended and also monitors the client’s sales ledger.