SOURCES OF FINANCE
WORKING CAPITAL MANAGEMENT
WORKING CAPITAL FINANCING
• Module 5
Sources of finance
Equity Capital
Internal Accruals
Preference Capital
Term Loans
Debentures.
Equity Capital
Equity Capital represents ownership
capital as equity holders collectively own
the company
Equity owners enjoy the rewards and
bear the risk of the ownership
Liability of equity owners is limited to
that of their contribution
Terms to be understood
Authorized capital – the potential amount company can
raise /issue as per memorandum
Issued capital – amount offered by company to investors
Subscribed capital – part of issue capital which has been
subscribed by investors
Paid up capital – The actual amount paid up by investors
Par value – Value stated in to memo
Issue price – Price at which the equity is issued
Book value – paid up equity capital+reserves/no. of
outstanding shares
Market value – Price at which it is traded in the market
Rights and position of equity
shareholders
Right to income
Right to control
Pre-emptive right
Right in liquidation
Advantages of equity
capital
No compulsion to pay dividends
No obligation to redeem
Enhances credit worthiness
For investors there is no tax on dividends
where as companies need to pay
dividend distribution tax
Disadvantages of equity capital
Dilutes the control/ownership
Cost of equity capital is high
Cost of issuing equity capital is higher
Equity Dividends are paid from profit
after tax hence a tax benefit is not
available to this in comparison to
interest payments
INTERNAL ACCRUALS
Internal accruals of a firm consists of depreciation charges and
retained earnings
Depreciation charges – is a non cash earning to the company as the
company debits depreciation of assets in balance sheet but in reality
there no expense that has gone out of the pocket
Retained earnings – refer to that portion of profit which is ploughed
back in the firm after paying taxes and preference dividends
Retained earnings are termed as “Reserves and Surplus “ in Balance
Sheet
Retained earnings are termed as internal equity(as equity
shareholders are sacrificing their share of profit for the firm)
Usually 30% to 80% of profit goes to RE.
They are a dominant source of long term finance
Retained earnings will also be utilized when bonus shares are issued
Advantages:
Easily and readily available
Eliminates issue cost and loss of under
pricing
No dilution of control/ownership
No negative connotation
Disadvantages:
The Amount that can be raised is limited
Opportunity cost of retained earnings is
high
Many a times firms do not fully utilize
the RE, hence the shareholders are hurt
due to inefficient utilization(after effect)
Preference Capital
Preference capital is a hybrid form of financing.
It takes some characteristics of equity and some attributes of
debentures
It is similar to ordinary shares that:
The non payment of dividends does not force the company to
insolvency
Dividends are non deductible for tax purposes
In some cases has no fixed maturity date
It is similar to debentures that:
Dividend rate is fixed
Preference share holders do not share the residual earnings
They have claims on income prior to ordinary shareholders
They usually do not have voting rights
Features
Claims on income and assets
Fixed dividend
Cumulative dividends
Redemption
Sinking fund
Call feature
Participation feature
Voting rights
convertibility
Advantages
Riskless leverage advantage
Dividend postponability
Fixed Dividend
Limited voting rights
Disadvantages
Non deductibility of dividends
Commitment to pay dividend
Term Loans
The long term debt raised by the firm is
referred to as term loans
Term loans are usually given by Banks
and financial institutions
Term loans are raised mainly to finance
the acquisition of fixed assets and
working capital margin
Features of term loan
Currency
Security
Interest payment and principal payment
Restrictive covenants
Advantages
Interest on debt is tax deductible
No dilution of control
No share in the value of firm
Maturity can be tailored
Issue cost of term loan is lower
Protection against inflation
Brings in discipline in the management
Easier management
Disadvantages
Fixed interest and principal payment
obligation
Increases financial leverage – leads to
raise in cost of capital according to CAPM
Limits firms borrowing and operational
flexibility
If inflation is low, then cost of debt
increases
Debentures
Debentures are instruments for raising
long term debt to the company
Debenture holders are creditors to the
company
Obligation of the company is to repay
interest and principal to the holder
Provides more flexibility in terms of
maturity, interest rate , security,
repayment etc.
Features
Trustee
Security
Interest rate
Maturity and redemption
Call and put feature
convertibility
Working Capital
Management
Nature of Working Capital
Working capital management is concerned with problems that
arise in attempting to manage the current assets and current
liabilities and the interrelationship that exists between them
Current Assets : Refer to those assets which in the ordinary course
of business can be or will be converted into cash within one year
without undergoing a diminution in value and without disrupting
operations of the firm
Ex : cash, marketable securities, accounts receivables and inventory
Current liabilities : are those liabilities which are intended at their
inception , to be paid in the ordinary course of business within a
year out of current assets or earnings of the firm.
Ex: Accounts payable, bills payable, bank overdraft and outstanding
expenses
The objective of working capital management
is to manage the firm’s current assets and
liabilities in such a way that a satisfactory
level of working capital is maintained
If the firm cannot maintain a satisfactory level
of W.C then it is likely to become insolvent
Current assets > current liabilities
The interaction between current assets and
current liabilities is the main theme of theory
of working capital management.
Concepts and definition
Gross working capital : Referred to as
working capital – means the current
assets
Net working capital- the difference
between the current assets and current
liabilities
It is also portion of current assets which
is financed with long term funds
Financial managers task is to manage the
liquidity in the firm in order to manage
working capital, NWC is one of the
Planning of working capital
The main aspects of planning of working
capital are
1. Need for working capital
2. Determinants of working capital
Need for working capital
Working capital is required to keep the
operating cycle running
Operating cycle refers to the continuous flow
from cash to suppliers , to inventory to accounts
receivables and back into cash
In other words, operating cycle refers to length
of time necessary to complete the following
cycle of events:
Conversion of cash to inventory
Conversion of inventory into receivables
Conversion of receivables into cash
The operating cycle thus creates the need
for current assets. This continuing need of
current assets gives rise to
1. Permanent working capital : refers to
certain minimum level of working
capital necessary on a continuous and
uninterrupted basis
2. Temporary working capital : refers to
the working capital needed to meet
seasonal as well as unforeseen
requirements
Changes in working capital requirement
Three basic reasons are:
1. Change in level of sales or operating
expense
2. Policy changes
3. Change in technology
Determinants of working
capital
General nature of business
Production cycle
Business Cycle
Production policy
Credit policy
Growth and expansion
Vagaries in the availability of raw material
Profit level
Level of taxes
Dividend policy
Depreciation policy
Price level changes
Operating efficiency
Working capital Financing
The principal sources of financing for
working capital are accruals, trade
credit, working capital advance, public
deposits, commercial paper etc
Accruals
The major accrual items are wages and
taxes
These are simply what the firm owes to
its employees and to the government
Wages are usually paid weekly,
fortnightly and monthly-those wages
which are owed but yet to be paid come
under accrued wages
Income tax/ taxes are payable quarterly/
half yearly – those taxes which are owed
but not yet paid come under accrued
Contd..
Accruals vary with level of activity of the
firm
Since there is no interest to be paid on
the accruals- they are regarded as free
source of financing
Although they seem to be free , accruals
actually carry a hidden cost with them
such as higher compensation in case of
wages and penalties and fines in case of
taxes
Trade Credit
Trade credit represents the credit extended by
the suppliers of goods and services.
It is a spontaneous source of finance
depending on the credit worthiness of the firm.
It is a important source of finance representing
25-50 percent of short term financing
Obtaining trade credit depends on the below:
1. Earnings record over a period of time
2. Liquidity position of the firm
3. Record of payment
For a newly established firm it is very
difficult to obtain trade credit . Hence
getting the confidence of suppliers, pre
conditions of trade credit can help
getting a credit for trade. Also cultivating
a good relationship helps build credit
worthiness.
Cost of credit depends on the terms of
credit offered by supplier
Commercial Banks
Working capital finance by commercial banks is
the most important source of finance
The aspects of sourcing through commercial
banks is as follows
1. Application and processing
2. Sanction and terms and conditions
3. Forms of finance – cash credit, loans,
purchase/discount bills
4. Letter of credit
5. Security
6. Margin
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