CHAPTE

WORKING CAPITAL FINANCE

R 31
 LEARNING OBJECTIVES
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 Explainthe benefits and costs of trade credit

 Focus on the norms used by banks in financing a
firm’s working capital need
 Emphasize the importance of commercial paper as
a method of working capital finance in India
 Short-term Sources of Finance
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 Trade Credit
 Accrued Expenses and Deferred Income
 Bank Borrowings
 Factoring of receivables
 Commercial Paper
 Trade Credit and Credit Terms
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 Refers to the credit that the customer gets from

supplier of goods in normal course of business.
 An informal arrangement, granted on an open
account basis, not formally acknowledge as a
debt.
 Trade credit may also take the form of bills
payable.
 Credit Terms refers to the conditions of due
date and cash discount.
 Benefits and Costs of Trade
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Credit
 Benefits
1. Easy Availability. Suppliers
Suppliers sometimes
sometimes offer
offer cash
cash discount
discount to
to
2. Flexibility. buyers
buyers for
for making
making prompt
prompt payment.
payment. Buyer
Buyer
should
should calculate
calculate the
the cost
cost of
of foregoing
foregoing cash
cash
3. Informality. discount
discount toto decide
decide whether
whether oror not
not cash
cash
discount
discount should
should be
be availed.
availed. The
The following
following
formula
formula can
can be
be used:
used:
 Costs
1. Implicit Cost.
2. Stretching A/P can prove to be very costly.
 Cost of cash discount
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 ACCRUED EXPENSES AND
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DEFERRED INCOME
 Accrued Expenses
 Accrued expenses represent a liability that a firm has to
pay for the services which it has already received.
1. Accrued Wages and Salaries.
2. Accrued taxes and Interest.
 Deferred Income
 Deferred income represents funds received by the firm
for goods and services which it has agreed to supply in
future.
1. Advance Payments.
 Bank Finance for Working
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Capital
 Overdraft
 Cash Credit
 Purchase or Discounting of Bills
 Letter of Credit
 Working Capital Loan
 Security for Bank Finance
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 Hypothecation
 Pledge
 Mortgage
 Lien
 Regulation of Bank Finance
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 Dehejia Committee (1968)

 Tandon Committee (1974)
 Chore Committee (1979)
In the deregulated economic environment in India
recently, banks have considerably relaxed their
criteria of lending. In fact, each bank can develop
its own criteria for the working capital finance.
 Dehejia Committee–Existing
Deficiencies
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 It is the borrower who decides how much he would borrow; the banker
does not decide how much he would lend and is, therefore not in a
position to do credit planning.

 The bank credit is treated as first source of finance and not as

supplementary to other source of finance.

 The amount of credit extended is based on the amount of security

available, not on the level of operations of borrower.

 Security does not by itself ensure safety of bank funds since all bad and
sticky advances are secured advances; safety essentially lies in the
efficient follow-up of the industrial operations of the borrower.
The Tandon Committee-Notions
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 Operating Plan
 Production Based Financing
 Partial Bank Financing
 The Tandon Committee-
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Recommendations
1. Inventory and receivable norms
2. Lending norms
3. Maximum Permissible Bank Finance (MPBF)
 First method
 Second method
 Third method
4. Style of credit
5. Information system
 The Chore Committee-
Recommendations
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1. Reduced Dependence on Bank Credit.

2. Credit limit to be separated into “peak level”
and “normal non-peak level” limits.
3. Existing Lending System to Continue.
4. Information System.
 COMMERCIAL PAPER
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 Unsecured promissory notes issued by firms to raise

short-term funds.
 In India, it was introduced in 1989 on
recommendation of the “Vaghul Working Group”.
 Commercial papers sell at a discount from face value.
 Merits
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1. It is an alternative source of raising short-term

finance.
2. It is a cheaper source of finance in comparison to
the bank credit.
3. From an investor’s point of view, it provides an
opportunity to make a safe, short-term investment
of surplus funds.
 Demerits
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1. It is an impersonal method of financing.

2. A firm facing temporary liquidity problems may not
be able to raise funds by issuing new paper.
3. The amount of loanable funds available in the
commercial paper market is limited to the amount
of excess liquidity of the various purchasers of
commercial paper.
4. It cannot be redeemed until maturity.