Types and Sources of Working Capital Finance

## Financing of Working Capital

### Introduction

Once working capital requirements are determined, the finance manager arranges funding based on the nature of the capital needed.

---

## Types of Working Capital Finance Sources

### 1. Spontaneous Sources

Arise naturally from normal business operations — no formal negotiation required.

• Trade credit
• Credit from employees (accrued wages)
• Credit from service suppliers

### 2. Negotiated Sources

Require specific negotiation with lenders.

• Commercial banks
• Financial institutions
• General public (public deposits)

---

## Factors Affecting Selection of Finance Source

1. Cost — interest rate, fees, implicit costs

2. Impact on Credit Rating — effect on the firm's overall borrowing capacity

3. Feasibility — availability of the source to this specific firm

4. Reliability — consistency of the source over time

5. Restrictions — covenants or conditions attached to the finance

6. Hedging/Matching Approach — match asset maturity with liability maturity

---

## Key Sources in Detail

### (a) Trade Credit

• Spontaneous; accounts for ~1/3 of total short-term requirements.
• Lower cost than other sources.
• Open Account Trade Credit: credit given without formal written instrument.

### (b) Bills Payable

• Purchaser gives a written promise to pay on demand or at a fixed date.
• Simple, easily available, lower explicit cost.
• Commonly used by SMEs.

### (c) Accrued Expenses

• Outstanding expenses for services already received (wages, salaries, taxes, duties).
• Interest-free, automatic, built-in source of finance.
• Helps maintain short-term liquidity.

### (d) Inter-Corporate Loans and Deposits

• Surplus funds invested by one company in another for short-term needs.
• Carries a higher interest rate than bank rate.
• Reduces dependence on bank finance.

### (e) Commercial Papers (CP)

• Unsecured promissory note for short-term funding.
• Available only to highly-rated corporates.
• Maturity: 7 days to less than 1 year; issued in multiples of ₹5 lakh.

Advantages:

• No restrictive covenants (unsecured)
• Continuous (new CP repays old)
• Maturity tailored to firm's needs
• Usable even in tight money markets
• Lower cost than bank loans

Limitations:

• Only for top-rated firms
• Cannot be redeemed early or extended after maturity

### (f) Funds from Operations

• Profit and depreciation directly increase working capital.
• Depreciation is a non-cash charge — a cost-free internal source of funds.

### (g) Public Deposits

• Short to medium-term source for large, established companies.

### (h) Bills Discounting

• Seller draws a bill of exchange; buyer accepts it.
• Seller discounts the bill with a bank for immediate funds.
• Governed by the Negotiable Instruments Act.

### (i) Bill Rediscounting Scheme

• Introduced by RBI on 1st November 1970.
• Promotes wider use of bills of exchange in trade.
• Scheduled banks can rediscount eligible bills with RBI.

### (j) Factoring

• Sale of trade debts at a discount to a financial institution.
• Continuous arrangement: client, factor, and debtor.
• Factor may or may not take recourse; also administers the sales ledger.

---

## Factoring vs Bills Discounting