Working Capital Financing By Banks

WORKING CAPITAL FINANCE

1 Working capital financing by banks

1.1 Trade credit

1.2 Bank finance

1.3 Commercial paper

Working Capital Finance

Working Capital Financing By Banks

A commercial bank is a business organization which deals in money i.e. lending and borrowing of money. They perform all types of functions like accepting deposits, advancing loans, credit creation and agency functions. Besides these usual functions, one of the most important functions of banks is to finance working capital requirement of firms. Working capital advances forms major part of advance portfolio of banks. In determining working capital requirements of a firm, the bank takes into account its sales and production plans and desirable level of current assets.

Cash Credit – Under this facility, the bank specifies a predetermined limit and the borrower is allowed to withdraw funds from the bank up to that sanctioned credit limit against a bond or other security. However, the borrower cannot borrow the entire sanctioned credit in lump sum; he can draw it periodically to the extent of his requirements. Similarly, repayment can be made whenever desired during the period. There is no commitment charge involved and interest is payable on the amount actually utilized by the borrower and not on the sanctioned limit.

Overdraft – Under this arrangement, the borrower is allowed to withdraw funds in excess of the actual credit balance in his current account up to a certain specified limit during a stipulated period against a security. Within the stipulated limits any number of withdrawals is permitted by the bank. Overdraft facility is generally available against the securities of life insurance policies, fixed deposits receipts, Government securities, shares and debentures, etc. of the corporate sector. Interest is charged on the amount actually withdrawn by the borrower, subject to some minimum (commitment) charges.

Loans – Under this system, the total amount of borrowing is credited to the current account of the borrower or released to him in cash. The borrower has to pay interest on the total amount of loan, irrespective of how much he draws. Loans are payable either on demand or in periodical instalments. They can also be renewed from time to time. As a form of financing, loans imply a financial discipline on the part of the borrowers.

Bills Financing – This facility enables a borrower to obtain credit from a bank against its bills. The bank purchases or discounts the bills of exchange and promissory notes of the borrower and credits the amount in his account after deducting discount. Under this facility, the amount provided is covered by cash credit and overdraft limit. Before purchasing or discounting the bills, the bank satisfies itself about the creditworthiness of the drawer and genuineness of the bill.

Letter of Credit – While the other forms of credit are direct forms of financing in which the banks provide funds as well as bears the risk, letter of credit is an indirect form of working capital financing in which banks assumes only the risk and the supplier himself provide the funds.

Working Capital Loan – Sometimes a borrower may require additional credit in excess of sanctioned credit limit to meet unforeseen contingencies. Banks provide such credit through a Working Capital Demand Loan (WCDL) account or a separate ‗non–operable‘ cash credit account..

1 Trade Credit

Trade credit is a form of short term financing common to almost all businesses. In fact, it is the largest source of short term funds for business firms collectively. In an advanced economy, most buyers are not required to pay for goods upon delivery but are allowed a short deferment period before payment is due. During this period, the seller of the goods extends credit to the buyer. Because suppliers generally are more liberal in the extension of credit than are financial institutions, small companies in particular rely on trade credit.

Three types of trade credit

^v   open account

^v   notes payable&trade acceptances by far the most common type is the open account arrangement. The seller ships goods to the buyer and sends an invoice that specifies the goods shipped, the price, the total amount due, and the terms of the sale. Open account credit derives its name from the fact that the buyer does not sign a formal debt instrument evidencing the amount owed the seller. The seller extends credit based upon a cred it investigation of the buyer.

In some situations, promissory notes are employed instead of open account credit. The buyer signs a note that evidences a debt to the seller. The note itself calls for the payment of the obligation at some specified future date. Promissory notes have been used in businesses such as those dealing in furs and jewelry. This arrangement is employed when the seller wants the buyer to recognize the debt formally. For example, a seller might request a promissory note from a buyer if the buyer's open account became past due.

A trade acceptance is another arrangement by which the indebtedness of the buyer is recognized formally. Under this arrangement, the seller draws a draft on the buyer, ordering the buyer to pay the draft at some date in the future. The seller will not release the goods until the buyer accepts the time draft.' Accepting the draft, the buyer designates a bank at which the draft will be paid when it comes due. At that time, the draft becomes a trade acceptance; and depending upon the creditworthiness of the buyer, it may possess some degree of marketability. If the trade acceptance is marketable, the seller of the goods can sell it at a discount and receive immediate payment for the goods. At final maturity, the holder of the acceptance presents it to the desigated bank for collection.

Because the use of promissory notes and trade acceptances is rather limited, the subsequent discussion will be confined to open account trade credit. The terms of sale make a great deal of difference in this type of credit. These terms, specified in the invoice, may be placed in several broad categories according to the net period within which payment is expected and according to the terms of the cash discount.

COD and CBD No, Extension of Credit: COD terms mean cash on delivery of the goods. The only risk the seller undertakes in this type of arrangement is that the buyer may refuse the shipment. Under such circumstances, the seller will be stuck with the shipping costs. Occasionally, a seller might ask for cash before delivery (CBD) to avoid all risk. Under either COD or CBD terms, the seller does not extend credit. CBD terms must be distinguished from progress payments, which are very common in certain industries. With progress payments, the buyer pays the manufacturer at various stages of production prior to actual delivery of the finished product. Because large sums of money are tied up in work in progress, aircraft manufacturers request progress payments from airlines in advance of the actual delivery of aircraft.

Net Period No Cash Discount: When credit is extended, the seller specifies the period of time allowed for payment. The terms "net 30" indicate that the invoice or bill must be paid within 30 days. If the seller bills on a monthly basis, it might require such terms as "net/15 EOM," which means that all goods shipped before the end of the month must be paid for by the fifteenth of the following month.

Net Period with Cash Discount In addition to extending credit, the seller may offer a cash discount if the bill is paid during the early part of the net period. The terms "2/10, net 30" indicate that the seller offers a 2 percent discount if the bill is paid within 10 days; otherwise, the buyer must pay the full amount within 30 days. Usually, a cash discount is offered as an incentive to the buyer to pay early.

Datings: In a seasonal business, sellers frequently use datings to encourage customers to place their orders before a heavy selling period. A manufacturer of lawn owners may give seasonal datings specifying that any shipment to a dealer in the winter or spring does not have to be paid for until summer.

2 Bank Finance

Banks generally do not provide working capital finance without adequate security. The nature and extent of security offered play an important role in influencing the decision of the bank to advance working capital finance. The bank provides credit on the basis of following modes of security:

Hypothecation

Under this mode of security, the banks provide working capital finance to the borrower against the security of movable property, generally inventories. It is a charge against property for the amount of debt where neither ownership nor possession is passed to the creditor. In the case of default the bank has the legal right to sell the property to realise the amount of debt.

Pledge

A pledge is bailment of goods as security for the repayment of a debt or fulfillment of a promise. Under this mode, the possession of goods offered as security passes into the hands of the bank. The bank can retain the possession of goods pledged with it till the debt (principal amount) together with interest and other expenses are repaid. . In case of non-payment of loan the bank may either; Sue the borrower for the amount due; Sue for the sale of goods pledged; or After giving due notice, sell the goods.

Lien

Lien means right of the lender to retain property belonging to the borrower until he repays the debt. It can be of two types: (i) Particular lien and (ii) General lien.

Particular lien is a right to retain property until the claim associated with the property is fully paid. On the other hand, General lien is applicable till all dues of the lender are paid. Banks usually enjoy general lien.

Mortgage

Mortgage is the transfer of a legal or equitable interest in a specific immovable property for the payment of a debt. In case of mortgage, the possession of the property may remain with the borrower, while the lender enjoys the full legal title. The mortgage interest in the property is terminated as soon as the debt is paid. Mortgages are taken as an additional security for working capital credit by banks.

Charge

Where immovable property of one person is made security for the payment of money to another and the transaction does not amount to mortgage, the latter person is said to have a charge on the property and all the provisions of simple mortgage will apply to such a charge. A charge may be created by the act of parties or by the operation of law. It is only security for payment.

3 Commercial Paper

Commercial paper is a fairly new instrument which was originated in US. It helps private companies with good credit rating to raise money directly from the market and investors. They raise money by issuing commercial papers in tight money market conditions through sources other than banks. CP is a fairly popular instrument and exists in most of the developed economies. Large corporate and private companies find CPs cheaper, simpler and more flexible due to their better credit rating.

By definition, CP is a promissory note issuing by leading, reputed and highly rated corporate to raise money for short-term requirements. In India, the maximum period (tenor) is 1 year.

Main Characteristics of Commercial Paper are

^v   Commercial paper is a short term debt instrument ( money market instrument) issued by both financial and non-financial companies.

^v   These debt instruments are unsecured in nature, that is, they do not require any change to be created on the company‘s assets.

^v   If the company fails to pay back the investors the amount of commercial papers after their maturity, the investors cannot sell a particular asset and recover their dues.

^v   Commercial papers are discount instruments, which mean they are issued at discount and redeemed at face value.

^v   IT can have different maturity periods but it varies within 1 yeat. In Inda, the matury period varies between 90 days to 365 days.

^v   In India, RBI regulates the commercial paper instruments. Companies have to adhere to the norms set by the RBI in order to raise money using commercial papers.

Benefits of Commercial papers:

^v   Investors get higher yield compared to other short-term investments

^v   These are more liquid in nature

^v   For the issuer, the rates are economical because they are in direct contact with the investors.

^v   Issuers can match the exact amount and maturity requirements of investors, and therefore gets favorable exposure to variety of investors.