Now let us discuss in detail the various sources of finance, which are mainly available for working capital and their relative merits and demerits.
Chart showing different sources of finance available for working capital
Now let us discuss in detail the various sources of finance, which are mainly available for working capital and their relative merits and demerits. The financial manager must look into different aspects such as cost, flexibility, reliability and restrictions whenever he selects sources of finance.
1. Financing Through Permanent Sources
Permanent sources of working capital should be provided in such a manner that the enterprise might have its uninterrupted use for an unlimited duration. It can be conveniently financed by the following sources.
A. Issue of Shares
Issue of shares is the most important sources for raising the permanent working capital. Shares are of two types – Equity shares and preference shares. Maximum amount of permanent working capital should be raised by the issue of equity shares.
B. Retained Earnings It means the reinvestment by a concern of its surplus earning in its business. This is, a part of the earned profits may be ploughed back by the firm, in meeting their working capital needs. It is an internal source of finance and is most suitable.
2. Financing Through Long-Term Sources The fund, which is required for 7 to 20 years and above, is called long-term funds. Financing of working capital through long-term sources provides reduction of risk and increases the liquidity. These long-term sources can be raised through the following methods.
a. Redeemable Preference Shares
Preference shares are those, which carry the following preferential rights over other classes of shares:
1. A preferential right to payment of fixed dividend over equity shareholder.
2. A preferential right to repayment of capital in case of winding up of the company to other classes of shares.
Redeemable preference shares are those, which can be redeemed during the lifetime of the company. According to the companies (Amendment) Act, 1996, w.e.f. March 1997, no company can now issue preference shares, which are irredeemable or are redeemable after 20 years from the date of their issue.
b. Debentures A debenture is an instrument issued by the company acknowledging its debt to its holder. It is also an important source of long-term working capital. The firm issuing debenture also enjoys a number of benefits, such as trading on equity, retention of control, tax benefit etc.
c. Long-Term Loans Financing institutions such as commercial banks, Life Insurance Corporation of India, industrial finance corporation of India, state financial corporations, industrial development bank of India etc. provide long-term and medium-term loans. This type of finance is ordinarily repayable in installments’.
3. Financing Through Medium-Term Sources The funds, which are basically required for a period of 2 to 5 years, are called medium-term funds. Previously the commercial banks were concentrating on short-term and medium-term loans in the form of working capital loans whereas the financial institutions like IDBI, ICICI, IFCI were concentrating on long-term funds. But, recently, the commercial banks have also entered into providing medium-term as well as long-term funds to trade and industry, either independently, or sometimes, in collaboration with one or more specialized financing institutions. The medium-term funds can be raised through the following methods.
a. Working Capital Term Loans It refers to the quantum of credit that a bank should disburse. Tandon committee suggested three methods of lending which banks generally follow the second method of lending. As per this method, the borrower will have to contribute 25% of the total current assets. The remaining working capital gap will be funded by bank borrowings. Where borrower fails to bring such additional funds, the banks usually sanction “Working capital term loans” which the borrower is to repay in a phased manner. Such repayment time allowed is a maximum of five years. To put a pressure on the borrower for early repayment of such loan, the banks generally charge 1% higher rate on such loans over and above rates charged in cash credit account. However, such excess charge of interest is entirely in the jurisdiction of the bank, which may discriminate between borrowers depending financial status and future project of the concerned borrower. The concept of “Working capital term loan” has been introduced by Chore committee, which was appointed for reviewing working capital lending by banks subsequent to introduction of recommendation of Tandon committee.
b. Public Fixed Deposits Public deposits are the fixed deposits accepted by a business enterprise directly from public deposit as source finance have a large number of advantages such as simple and convenient source of finance, Taxation benefits, inexpensive sources of finance etc.
c. Medium Term Loans These loans are generally provided by banks or financial institutions. The period of loans vary from 3 to 7 years. The investment of these loans from funds is in plant and machinery, vehicle and certain other equipments. The procedures of granting such loan may not be as high as in case of long-term loans. Besides, in most cases consortium finance may not be required. In case of long-terms, the funds are invested in freehold land or in long leased land since their period of loan vary from 7 years to 20 years. Thus the difference between medium term loans and long-term loans may be termed as of degree rather than of kind.
4. Financing Working Capital Through Short-Term Sources Funds available for a period of one year or less are called short-term sources of finance. They are raised from sources, which can provide funds only for short period quickly, and its cost is less than the funds raised from long-term sources. These funds are usually met by taking short-term loans or getting the bills discounting from the commercial banks. Spontaneous sources and bank loans are important sources of short-term funds. They are explained in detail below.
Tags : Financial Management - WORKING CAPITAL MANAGEMENT
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