Working Capital Finance
LEARNING CBJECTIVES
E>cplalrl the benefits and cos1s of 1rode aedlt
Focus on the nonns used by banks In financing a firm's working capital need
. Emphasize the Importance of cammerdal paper as a me1hod of working capital finance In India
INTRODUCTION
External funds available for a period of one year or less
are called short-term finance. In India, short-term funds
are used to finance working capital. Two most significant
short-term sources of finance for working capital are: trade
credit and bank borrowing. The use of trade credit has
been increasing over years in India. Trade credit as a ratio
of current assets is ab011t 40 per cent. Bank borrowing is
the next important source of working capital finance.
Before the 70s, bank credit was liberally available to firms.
It became a restricted resource in the 80s and 90s because
of the change in the government policy; banks were
required to follow the government prescribed norms in
financing working capital requirements of firms. Now
there are no government norms, and banks are free to take
business decisions in granting finance for working capital.
Two other short-term sources of working capital
finance which have recently developed in India are:
(1) factoring of receivables and (ii) commercial paper. We
have already discussed factoring in an earlier chapter.
TRADE CREDIT
Trade credit refers to the credit that a customer gets from
supplier,; of goods in the normal course of business. In
...
practice, the buying firms do not have to pay cash
immediately for the purchases made. This deferral of
payments is a short-term financing called trade credit. It
is a major source of financing for firms. In India, it
contributes to about one-third of the short-term financing.
Particularly, small firms are heavily dependent on trade
credit as a source of finance since they find it difficult to
raise funds from banks or other sources in the capital
markets.
Trade credit is mostly an informal arrangement, and
is granted on an open account basis. A supplier sends
goods to the buyer on credit which the buyer accepts, and
thus, in effect, agrees to pay the amount due, as per sales
the terms in the invoice. However, he does not formally
acknowledge it as a debt; he does not sign any legal
instrument. Once the trade links have been established
between the buyer and the seller, they have each other's
mutual confidence, and trade credit becomes a routine
activity which may be periodically reviewed by the
supplier. Open account trade credit appears as sundry
creditors (known as accounts payable in USA) on the
buyer's balance sheet.
Trade credit may also take the form of bills payable.
When the buyer signs a bill-a negotiable instrument-
to obtain trade credit, it appears on the buyer's balance
 Working Capital Finance 741
t as bills payable. The bill has a specified fu . . , sales reduce,
shee. usually used when the supplier is 1 ture date, credit. In contrast, if the firm s 1 trade
arid ,:5 yer's willingness and ability to payess sure about purchases will decline and consequent Y
,,e vU h b d' , or when th
v• ·uer wants cas y iscounting the bill f e ,.,."" credit
f will also decline. d ' . n inforrna. 1, \\
,upt is torrnal acknowledgement of an obli ~om a bank, In ormality Trade ere it 1s a
spontaneous source of finance. It does not reqduire
p.b1outstanding amount. In USA, promis~: on to repay ent It oes \
tJie I acknowledgement of an obligation .;: notes-:-a any negotiations and formal agreem · ts pi
I
foflil:y on a specified date-are used as a:ailt a pr?mise not have the restrictions which are usually par I

to P d h ernative to of negotiated sources of finance. 11

e open account, an t ey appear as notes . l
th '-uyer's balance sheet. payable m Is trade credit a cost-free source of finance? It appearst
the u to be cost-free since it does not involve explicit intereS t
charges. But in practice, it involves implicit cost: The coS
credit Terms of credit may be transferred to the buyer via the mcreas~d
price of goods supplied to him. The user of trade credit,
Credit terms refer tod .the conditions unde r w h'ic h the therefore, should be aware of the costs of trade credit to
supplier se 11 s on ere
h it to
. the buyer , and th b .
e uyer is make use of it intelligently. The reasoning that it is cost-
required to repay t e cr~dit. These conditions include the free can lead to incorrect financing decisions.
due date and the cash discount (if any) given for prom t
payrnent. Due ~ate (also called net date) is the date J The supplier extending trade credit inc1:11's costs ?1
which the supplier expects payment. Credit terms • di y the form of the opportunity cost of funds invested m
h db · · d m cate accounts receivable and cost of any cash discount taken
the Jengt . an egmrun? ate of the credit period. Cash by the buyer. Does the supplier bear these costs? Most of
discount is the concession offered to the buyer b yth e the time he passes on all or part of these costs to the buyer .I
supplit er o encourage him to make payment prom tl implicitly in the form of higher purchase price of goods
i
The cash discount can be availed by the buyer if h p y. , I
· d t hi h · e pays and services supplied. How much of the costs can he really I ;
I
by a cer~am a e w c is ~uite earlier than the due date. pass on depends on the market supply and demand
The typical way of expressing credit terms is for exa l
'3/ 5 ' mp e, conditions. Thus if the buyer is in a position to pay cash
as follows: 1 , net 45'. This implies that a 3 per cent immediately, he should try to avoid implicit costs of trade
discount is available if the credit is repaid on the 15th da credit by negotiating lower purchase price with the
and in case the discount is not taken, the payment is dJ~
supplier.
by the 45th day.
Credit terms sometimes include cash discourit if the
payment is made within a specified period. The buyer
Benefits and Costs of Trade Credit should take a decision whether or not to avail it. A trade- .i
off is involved. If the buyer takes discourit, he benefits in
A:5 stated earlier, trade credit is normally available to a
terms of less cash outflow, but then he foregoes the credit
firm; therefore, it is a spontaneous source of financing. granted by the supplier beyond the discourit period. In
As the volume of the firm's purchase increases, trade credit
contrast, if he does not take discount, he avails credit for
also expands. Suppose that a firm increases its purchases the extended period but pays more. The buyer incurs an
from Rs 50,000 per day to Rs 60,000 per day. Assume that
opportunity cost ~hen he does not avail cash discourit.
these purchases are made on credit terms of 'net 45' and Suppose that the Nrrmal Company is extended Rs 100 000
the firm makes payment on the 45th day. The av;rage
cr~dit on terI?5 of '2/15, net 45'. As shown in Figure 31.1,
accounts payable outstanding (trade credit finance) will ::1ll1I\al can either pay less amo~t(l00,000-0.02 x 100,000
expand to Rs 27 lakh (Rs 60,000 x 45) from Rs 22.50 lakh
- Rs 98,000) by the end of the discourit period i.e. the 15th
(Rs SQ,QQQ X 45).
1 daY_ or ~e full amount (Rs 100,000) by the end of the credit
The major advantages of trade credit are as follows: penod, i.e., the 45th day. If the firm foregoes cash discount
Easy availability Unlike other sources of
finance, trade credit is relatively easy to obtain.
Except in the case of financially very unsound Credit period Less amount due Full amount due

-j
firms, it is almost automatic and does not require begins Rs 98,000 Rs 100,000
any negotiations. The easy availability is t0 15 1 t 1 I I 1 -l45
particularly important to small firms which 10 ts 20 25 30 35 40
1
generally face difficulty in raising funds from the Discount period Additional period
capital markets.
Flexibility Flexibility is another advantage of
trade credit. Trade credit grows with the growth Credit period
in firm's sales. The expansion in the firm's sales
~auses its purchases of goods and services to
mcrease which is automatically financed by trade
L....----::.~--:=-::-:=----=========::~ \
Figure 31.1: Cost of cash discount
. .
Moyer, R.C., et. Ill., Contemporary Financial Management, West Publishing Co., 1980, p. 666.
 742 Financial Management
and does not pay on the 15th day, it can use Rs 98,000 for
an additional period of 30 days, and implicitly paying Rs
2,000 in interest. If a credit of Rs 98,000 is available for 30
days by paying Rs 2,000 as interest, how much is the
annual rate of interest? It can be found as follows:
. . interest
I mp11c1t . rate =2,000
--x - = 0.245 or 24 .501
360 lo
98,000 30
We can also use the following formula to calculate
the implicit rate of interest:
Implicit interest rate:
% Discount
100 - % Discount x Credit period - Discount period (1)
Using data of our example, we obtain:
2 360
= -- x ~ = 3 - x =0.245 or 24.5%
100-2 45-15 98 30
As the example above indicates, the annual
opportunity cost of foregoing cash discount can be very
high. Therefore, a firm should compare the opportunity
cost of trade credit with the costs of other sources of credit
while making its financing decisions.
For meeting its financing needs, should a company
stretch its accounts payable? When a firm delays the
payment of credit beyond the due date, it is called
stretching accounts payable. Stretching accounts payable
does generate additional short-term finances, but it can
prove to be a very costly source. The firm have to
forgo the cash discount and may also be reqwred to pay
penalty interest charges. Thus the firm _will no! only ~e
charged higher implicit costs, but its creditworthiness will
also be adversely affected. If the firm stretches accounts
payable frequently, it may not be able to obta~ anf credit
in future. It may also find it difficult t~ obta_m ~ances
from other sources once its creditworthiness IS senously
damaged.
CHECK YOUR CONCEPTS
1. What is trade credit? What are the forms of trade
credit?
2. Give three beneftts of trade credit
3. What are the costs of trade credit as a source of short- ,
Accrued Expenses
Accrued expenses represent a liability that a firm has to
pay for the services which it has_already received. Thus
they represent a sp~ntaneous, mterest-free sources of
financing. The most importan~ component of aCCJ'Uals is
wages and salaries, taxes and interest.
Accrued wages and salaries represent obligations
payable by the firm to its employees. The firm incurs a
liability the moment employees have rendered services.
They are, however, paid afterwards, usually at some fixed
interval like one month. The longer the payment interval,
360 the greater are the amount of funds provided by the
employees. Legal and practi~al aspects cons~ain the
flexibility of a firm in lengthening the payment interval
Accrued taxes and interest constitute another source
of financing. Corporate taxes are _Paid after the has
earned profits. These taxes are paid q~e~ly dunng the
year in which profits a~e e~med. This 1~ a deferred
payment of the firm's oblig~tion_and ~us'. IS a sour_ce of
finance. Like taxes, interest IS paid penodically dunng a
year while the firm continuously uses the borro~~ fun~.
Thus accrued interest on borrowed funds requrrmg semi-
annual interest payments can be used as a source of
financing for a period as long as six months. Note that
these expenses are not postponable for long and a firm
does not have much control over their frequency and
magnitude. It is a limited source of short-term financing.
Deferred Income
Deferred income represents funds received by the firm
for goods and services which it has agreed to supply in
future. These receipts increase the firm's liquidity in the
form of cash; therefore, they constitute an important source
of financing.
Advance payments made by customers constitute the
main item of deferred income. These payments are
common in case of expensive products like boilers, ·
turnkey projects, large contracts or where the prod~c~ is
in short supply and the seller has a strong bargammg
power as compared to th~_b uyer. These payments are not
recorded as revenue until goods and services have been
delivered to the customers. They are, therefore, shown as
a liability in the firm's balance sheet.

tennfunds? ~ -·····-.., ·•<i- •--·· _ .. ~-~-·- ·'·~· ·· __ ,, ·· - · ,.I

CHECK YOUR CONCEPTS
....... ·.•-··· --=: .... __ ,.. .~, •••

ACCRUED EXPENSES AND

l. What are accrued expenses? Give examples of '
DEFERRED INCOME accrued expenses. •
In addition to trade credit, accrued expenses and deferred 1 2. What ls meant by deferred income? What are the

income are other spontaneous sources of sh~rt-term examples of deferred income?

financing.2 Accruedexpensesareamfirmoreauto~aticso~ce i 3. Why are accrued. expenses and deferred income
since, by definition, they permit the to receive seMces sources of short-term finance?
before paying for them. ....... ....._ .. '

2. Moyer, et. al., op. cit., 1980, P· 667,

 Working Capital Finance 743
SANK FINANCE FOR WORKING CAPITAL circumstances. Cash credit is a most flexible arrangement
from the borrower's point of view.
n ••
I><"-
,s
are the main
· finstitutional sources of workin g capital
.
Purchase or discounting of bills Under th~chase or
fiJlallce in India. A ter trad~ credi~, bank credit is the most
_siiscounting.o.£ billsd J,orrowe!..£@...Q~t,1.in credit fro~
·~portant sourceb of hnancmg
1~• . working capita • 1 _bank <!gaiPstits.bills1Ihe bank purchases or discoun!s
requirements. A ank cm:~siders a firm ' s sales and the borrower's bills. 'rhe amount provided under this
productio~ p_lans_ and the ~esirabl~ levels of current assets agreement is covered within the overall cash credit or
in deternumng its workmg capital requirements. The overdraft limit. Before purchasing or discounting the bills,
a,tnolln!.!!PJ?.roved bl !h~ bank for thtiir.m's worfiru: the bank satisfies itself as to the creditworthiness of the
~£~js~~hlll;1~ t is the maximu! drawer. Though the term 'bills purchased' implies that
ainount of funds which a firm can obtain from the bankin · the bank becomes owner of the bills, in practice, bank
system. case of firms. with seasonal busines ses, g holds bills as security for the credit. When a bill is
1,aru(S may fix separate limi ts for the peak level cred"t
§~ement _a~d ~ormal, n~n-£!_ak level
r~~CMIJ,lg_the periods dugI\g_whidL.the..
d!:ttt discounted, the borrower is paid the discounted amount
of the bill (viz., full amount of bill minus the discount
charged by the bank). The bank collects the full amount
~ r a ~.ill be y ~ d by_tll~_borrow~ In practice on maturity.
banks do no~ lend 100 per c~nt of ~credit limit; the; To encourage bills as instruments of credit, the
deduct inargtn money. Margm requirement is based on Reserve Bank of India introduced the new bill market
the principle of conservatism and is meant to ensure scheme in 1970. The scheme was intended to reduce the
security- If the margin requirement is 30 per ce,;t, bank borrowers' reliance on the cash credit system which is
will lend only up to 70 per cent of the value of the asset. susceptible to misuse. It was also envisaged that the
This implies that the security of bank's lending should be scheme will facilitate banks to deploy their surpluses or
maintained even if the asset's value falls by 30 per cent. deficits by rediscounting or selling the bills purchased or
discounted by them. Banks with surplus funds could
Forms of Bank .Finance repurchase or rediscount bills in the possession of banks
with deficits. There can be situation where every bank
A furn can draw funds from its bank within the maximum wants to sell its bills. Therefore, the Reserve Bank of India
credit limit sanctioned. It can draw funds in the following plays the role of the lender of last resort, under the new
f~rms: (a) overgraft, (b) cash credit, (c) bills purchasing or bill market scheme. Unfortunately, the scheme has not
discounting, and (d) working capital loan. worked successfully so far.
' Unde0he_pye!dn 1ftj acility, the. bo!~?:"'!! ~iL Lette,: qJ _':.~'E.t SuppliersL_particuJarly_t~E:,,lli~gn
Overdrafr
allowed to withdraw funds in excess of the balance in his suppliers, msist that the buyer _§hould ensure that his bank-
current account, up to~ ~t_a~,2E~ifie4 jimit, d~__! will Jl\ak.~~E:.P~~ent if !_le failstohonour ifs o bligati,;n.
sllpul~no:U,'\Though overdrawn ·amount is This is ensured through· a lette r of cre dit (LiC )
repayable on demand, it generally continues for a long arrangement. A bank opens an L/C in favour of a
penod by annual renewals of the limits. It is a very flexible customer to facilitate his purchase of goods. If the
arrangement from the borrower's point of view since he customer does not pay to the supplier within the credit
can withdraw and repay funds whenever he desires within period, the bank makes the payment under the L/C
the overall stipulations. Interest is charged on daily arran~ement. This arrangement passes the risk of the
balances-on the amount actually withdrawn-subject to supp~ier to the bank_- Bank charges the customer for
some minimum charges. The borrower operates the openmg the L/C. It will extend such facility to financially
account through cheques. sound customers. Unlike cash credit or overdraft f ility
_th~ L/C arrangement is an indirect financing; th:cbank.
~shsiedit The cash c~it facility ~~i{nil~s._ t~ the will make payment to the supplier on behalf of th
~~n~:~e~t].!!.~s t~e ~ gs! P?Ptilarmet~ ~ customer only when he fails to meet the obligation. e
finance for worllng capital m Indial!Jnder the cash
:U 1fa,~.orrower is allov.:,~~~th~raw_ ~d~ ~gr~ing capital 1loan __ A borrower may sometimes
. !1:\ theJ:,ank_upto the sanctiql_l.~Sr~d!!,_~~ He is not reqmre ad hoc . or temporary accommodati·on, m . excess of
teqlllred le borrow the entire sanctioned credit at once, t h e .sanctioned. credit limit , to me e t un f oreseen
rather
. , he can draw periodically to the extent o f h ~s " contingencies. &ank~ yide such accommodat'
~lllrements_ and repay it by depositing s~lus funds~ through a demand loan acc~ t o r ~ ~parate ion
the:r cr~dit account.(Ihere is _no C?~tment charge, ~perable t cash credit account
hi _ ·lThe borrower -~'°".0
-· -.1s required
~-
~~re, interest is payable on t~ ~ f y _o pay a gher rate of interest above the normal rat 0 f
°ajains~?Ythe bonower1Casncredit limits are sane~~ ~ mterest on such additional credit. e
boi-ro~ the- securey:olwrenU/?.~ Tnougf\'funds Exhibit 31.1 details State Bmk of India's p d
recau ed are repayable on demand, banks usually do not for working capital finance. roce ures
5uch advances unless they are compelled by adverse
 EXHIBIT (~ O~---;~ I~ ~~E 1 customers with highest integrity. They do not u
grant hypothecation facility to new borrowers. suauy
- • ·i BYSBI . 1
3~•-~••·''-'-.'.-'.1C?k,K?,..J,:;,,,c.t,;,',t,i;\:l,'•_0.r.!-i'11'.'i7,{/,:;c,·,:•:,.-r,.,::,_<',-i, borrowerisreqUir
• How is working capital finance typically structured at I tpJ:ransfet<theph-y.sicaJ..Eossessi~!!_ of th~ property O :
as a security to~theJ >ank..!f>_9P~cr~~~e oank fiasi'
SBI? ' right of lien and can retain possession o the goods pied a
Ac SBI, working capital loans are tailored co suit die . · · 1, mterest
until payment o f t h e pnnc1pa · Sed
and any Oth
precise requirements of the client, in any of the ~i~us expenses is made. In case of default, the bank may eith:
instruments available or strucrured as a combmauon (a) sue the borrower for the amount due, or {b) sue for th
of cash credit, demand loan, bill financing and non-
funded facilities.
sale of goods pledged, or (c) after giving due notice,
the goods.
se;
The bank's accomplished credit crew can gauge the
credit needs of each client and frame the exact solutions. Mortgage Mortgage is the transfer of a legal or equitable
• How does SBI approve working capital loans? ~~es.t_in a~sf>e.!:ifi~jnunoy.c!~le pro e for the a ~ t
SBI's dedicated credit team has a deep understanding of a .3,eJ1;., In case of mortgage, the possession O t e
of the intricacies of various industries and is richly property may remain with the borrower, with the lender
experienced in reckoning the business potential of getting the full legal title. The transferor of interest
(borrower) is called the mortgagor, the transferee Cbank)
companies. ·
is called the mortgagee, and the instrument of transfer is
These informed professionals can assess your specific i called the mortgage deed.
credit requirements and tailor customized financial
solutions to suit your risk profile and the working capital .J
!
The credit granted against immovable property has
some difficulties. They are not self-liquidating. Also, there
cycle of your company. . J are difficulties in ascertaining the title and assessing the
• What are the tenors for which SBI extends working j
capital finance? . , 1 value of the property. There is limited marketability, and
therefore, security may often be difficult to realize. Also,
Normally working capital finance is extended as a 'limit' .i without the court's decree, the property cannot be sold.
for various facilities for tenors up to on~ year. J\d hoc' Usually, for working capital finance, the mode of security
requirements are also considered. !
is either hypothecation or pledge. Mortgages may be taken
• How are SBI working capital loans priced? \ as additional security.
The loans normally carry on a floating interest rate j
linked to SBAR, the SBI prime lending rate for working ,l Li~1!,E_t~c!!!,~ _rjght lender_to retain property
capital finance. Certain self-liquidating shon-term loans ; ~':l~ ~giEg_ to.Jlle porro~ e~-~ til_li~ ~el'~Ys,,c~ed~ilt_ c~ be
are also linked co the bank's Short Term Advance Rate j either a particular lien or general lien. Particular lien IS a
(SBSTAR). - I
right to retain property until the claim associated with
• What is the repayment schedule like? · the property is fully paid. General lien, on the other hand,
is applicable till all dues of the lender are paid. Banks
Working capital finance limits are normally valid for_,;
usually enjoy general lien.
one year and repayable on demand. Specific, self- }
liquidating loans are linked to the natural tenor of the )
transaction (bill finance, export credit, etc.). 1 CHECK YOUR CONCEPTS
Source: www.statebankofindia.com J• J
- . ~--- -~- ·-- = ~ ~- _ _J L What is meant by credit limit? 1
\ 2. What are peak-level and non-peak level credit limits? \
Security Required in Bank Finance
j 3. What are the types of bank finance for financing j
Banl<s generally do not provide working capital finance working capital? Briefly explain each one of them. 1
without adequate security. The following are the modes 4. What kinds of security does a bank require when it 1,
of security which a bank may require.
L~- ___extends finll!l.ces for_working cap)~ 1
Hypothecation Under h)'.Pothecation, tru!.b~~t~
P£~yfdeti :with.working capital finance by the bank a g ~ REGULATION OF BANK FINANCE
t~e security ~fJP.Q.Y!ible property generalJy invento~s,
rty to the bank;
t
The borrower does not
her· ·- made availa
Banks have been following certain norms in granting
working capital finance to companies. These norms
as ~ c...__ ......,~:"."::"~ tion is a charge guidelines have been greatly influenced by ~e
·~g · debt where neither recommendations of various committees appointed by ~
ownership nor possession is passed to the credit~ Banks Reserve Bank of India from time to time. 1:'e nor:
0
erally grant credit hypothecation only to~t class working capital finance followed by bank since nu
705