APPROACHES TO DETERMINE FINANCING OF WORKING CAPITAL
Financing of working capital
is a very important decision to be made. It can be done both internally and
externally. It is generally believed that short-term sources should be utilised
for raising working capital but this has changed. There are three approaches
to finance it:-
1) Hedging approach: under this all fixed and permanent current assets are
financed through long term loans and all current temporary working capital
through short term funds.
2) Conservative approach: Mostly everything is financed through long term
loans. Short term funds are used only during peak seasonal requirements and
during off-season the extra could be invested in marketable securities.
3) Aggressive approach: under this most of the funds are raised through short
The selection of the source depends on the risk taking capacity of the firm.
Various sources of long term finance:-
1)Issue of shares: The amount required can be divided into shares that
investors can buy for part ownership in the company. Include equity and
preference. Issued through an IPO, issue house, etc.
2) Issue of debentures: This means raising loans from the public by giving them
‘units’ known as debentures. There is fixed interest payable on these.
3) Loans from financial institutions: Government has set up various
institutions to help companies finance their operations
4) Retained profits: keeping/ ploughing back part of the profits to use.
5) Public deposits: The company issues an advertisement inviting the public to
deposit their savings with the company for up to 3 years for a specified rate
Various sources of short term finance:-
1) Trade credit: It refers to the amount to be paid to the suppliers after a
particular period of time which is generally less than 1 year.
2) Bank loans and advances: Companies generally take up secured bank credit to
meet their operating expenses.
3) Short term loans from finance companies
In conclusion it depends on the company’s ability to take risk that helps them
decide the approach to finance working capital. Also there are numerous ways to
finance working capital which requires effective analysis to be chosen.
WORKING CAPITAL FINANCING BY BANKS AND ITS REGULATION
Working capital is the amount required to finance the day to day operating
activities of a business. One of the main sources to get funds are banks. Banks
determine the working capital requirement of a firm by its sales, production
and favourable level of current assets, the amount thus approved is called
credit limit. This may differ for seasonal businesses. They are usually given
against security of current assets. Available in these forms:-
1) Cash credit: Company is allowed to withdraw funds up to a predetermined
limit sanctioned against a bond or some other security. It cannot be withdrawn
in lump sum. Repayment is made as and when the borrower wants within the time
period. Interest is charged on the funds actually used.
2) Overdraft: The borrower is allowed to withdraw over the amount actually in
3) Loans: The amount is credited to the borrower and the borrower has to pay it
back with interest on demand or by instalments.
4) Bills financing: Bills of exchange are discounted with the bank and the
amount is covered by cash credit or overdraft limit. The banks check the creditworthiness.
5) Letter of credit: Banks provide a letter stating that if the buyer doesn’t
make the payment in time the bank will do it on his behalf. It is more like a
guarantee the bank provides to its clients supplier
6) Working capital loan: When additional funds over the credit limit are
required banks provide it through Working Capital Demand Loan account or a
separate non-operable cash credit account. Given to those whose working capital
is over 10 crores.
Banks provide funds to the companies on the basis of certain modes of security:-
1) Hypothecation: Funds provided against security of movable property (like
inventory). Ownership and possession remain with the borrower but if there is a
default the bank can sell the property.
2) Pledge: Goods offered as security go to the bank and they can keep it till
the loan and interest has been repaid, in case of non-payment they can sue or
sell the goods after giving a notice.
3) Lien: The bank can retain the property till the debt is repaid. There are
two types: particular lien and general lien.
4) Mortgage: Legal title of any immovable property goes to the lender while the
5) Charge: when one’s property is made security of another’s loan. Provisions
of mortgage apply.
There are various rules and regulations on the amount of credit a bank can
provide for the simple reason of to bring about discipline in borrowers and to
ensure equitable distribution among sectors. The recent changes in the
regulations are abolishment of maximum permissible bank finance (MPBF), it
isn’t necessary to have consortium arrangements for financing working capital
beyond 50 crores, RBI has also issued certain lending norms for working
CAPITAL FINANCING POLICY AND PROFITABILITY: BANGLADESH
An aggressive finance policy uses higher levels of
current liabilities whereas a conservative policy uses more of long term
sources of funds. It is important for the manager to think rationally before
making the decision about the approach to be used to finance working capital.
This research paper mainly focus on the impact of working capital financing
policy on profits from the view point of a developing nation that is
Bangladesh. The study about 80 manufacturing companies that are listed on the
Dhaka Stock Exchange (DSE) over a period of 2009-2014 and employed fixed effect
panel data regression technique. Only manufacturing companies were used to
maintain homogeneity. Variables taken into account were Return on Assets,
Financing Policy, Firm growth, financial leverage and firm size. The result of
the regression showed that there is a negative relationship that exists between
the working capital financing policy and return on assets. This signifies that
higher the current liabilities taken up to finance the assets of the firm lower
will be the return on assets. Even though short term financing are cheaper when compared to all
the long term borrowing measures such as stock, bond, etc. there is a lot of
cost of managing the current liabilities which in turn increase the cost of the
funds as a whole. Also in short term financing the refinancing risks are high.
The study result could also be due to the fact that the money market is thin in
Bangladesh which limits its scope to use short term finance. Companies there
also do not allow a lot of credit. This study mainly uses only large firms
leading to possible changes in results of medium and small enterprises. It is
advisable for them to use a more conservative approach that is to finance their
working capital mainly through long term financing sources.
FINANCING OF WORKING CAPITAL-LOANS AND ADVANCES
There are multiple differences in financing working capital through short term
or long term sources. Long term sources can tend to get more expensive due to
the regular interest payments required but short term sources can be more risky
as they may sometimes not be readily available leading to getting the loans at
higher and inconvenient rates, also financing permanent current assets through
short term loans can get costly as arrangements for new sources of short term
financing need to be made continuously. The short term financing sources are
current liabilities. Loans and advances are also current liabilities and taken
up in this study. Loan is when one party gives/lends certain amount of money to
another party with predetermined terms of payment and interest. It helps in
flexibility in business operations due to availability of funds, it is used to
make payment for current liabilities, they are found to be economical, autonomy
over funds, convenient, and carry secrecy. Various ratios were used to analyse
the data on certain paper companies. The main purpose of the study is to find
out if there is significant difference in loan and advance to current asset
ratio and working capital ratio or not. It was found that those companies whose
loan and advances to current asset ratio was not very high would benefit if
they used this short term financing method to fund their operating expenses.
They could easily increase their current liabilities in this form. For the
companies that had higher loan and advances to working capital ratio it is
advisable to increase current liabilities. This research could have had
different results if a larger sample was taken (this consisted of only 10 companies)
and this entire study is based on ratio analysis which in itself has certain
limitations. Basically any business
should finance through loans and advances only if it willing to take all the
risk involved with current liabilities or if the current asset base is strong.
AN EVALUATION OF CHANNEL FINANCING AS A MODE OF
WORKING CAPITAL FINANCE
Channel financing or supply chain finance enables Original Equipment
Manufacturers (OEM) to provide working capital support to the channel partners
at a certain rate of interest through banks or financial institutions. It helps
small channel partners to transfer their risk on their customer and attain
lower borrowing cost. Cash flows can be improved if all the money owing to the
business get collected faster which is enabled by channel financing. It is
found in the study that channel financing leads to better management of working
capital of suppliers by decreasing the working capital cycle. Due to this the
OEM’S are in better position to negotiate better rates, terms and conditions
with the partners. It is essential to choose the right banking partner, involve
and critically assess suppliers place weightage on economic factors such as
business volume with suppliers. Channel financing has the potential to reduce
the cost of goods purchased, improved days payable outstanding, stable and
reliable supply base, and improved relations. It also helps improve inventory
management of the manufacturer. Better utilization of working capital limits,
early payment discounts and many other benefits. The study showed a multiplier
effect on business of supplier firms and consist of well predicted cash flows
which affect the business positively. In the study when the suppliers were
asked if they required any other mode of finance it was found that they didn’t.
Banks are provided with competitive advantage of being with large firms as well
as being associated with channel partners. It has become an attractive business
model for banks as it gives them better insights into industry business, gives
them a perception of risk-adjusted business growth, increase customer base and
also better tool of credit risk management due to less probability of financial
loss. It was found that a majority of channel partners were SMEs which in turn
helped development the entire economy. Banks check certain details before
entering into the transaction such as track record and duration of business
between OEM and partner, credit rating of channel partner, turnover, financial strength,
percentage of business of OME with channel partner, etc. Extends benefits to
Database References used:
1 Dhiman, Amit. APPROACHES TO WORKING
R. WORKING CAPITAL FINANCING BY BANKS AND IT’S REGULATION.
3 Thakur, O. A., & Muktadir-Al-Mukit, D.
Working Capital Financing Policy and Profitability: Empirical Study on
Bangladeshi Listed Firms.
4 HALANI, P. (2015). FINANCING OF WORKING
CAPITAL LOAN AND ADVANCE MANAGEMENT.
5 Yogini, C. (2013). An evaluation of channel
financing as a mode of working capital finance a case study of selected large
scale engineering industries in and around Pune city.