Project Planning and Control

Working Capital – Meaning and Sources of Working Capital

Working capital is the amount of money required by an enterprise for carrying out its day to day operations. The money invested in current assets like raw materials, finished products, debtors etc. is known as working capital. The current assets in aggregate refer to gross working capital and to arrive at net working capital, current liabilities such as sundry creditors, bills payable etc. have to be deducted from the gross working capital. The working capital is of two types.

(1) Permanent Working Capital – Permanent working capital represents the amount of current assets needed to carry out operations at any time. These assets are required on a continuing basis throughout the year.

(2) Variable Working Capital – Variable working capital represents additional assets required at certain times during the year. The requirements of working capital will depend upon a numbers of factors e.g..

  • Operating cycle
  • Sales volume
  • Seasonal and cyclical fluctuations
  • Policies of the firm Technology changes
  • Size of the firm
  • Availability of credit etc.

Estimation of operating costs of a project gives an idea about the amount of working capital required. It is still essential to observe operating activities and estimate the level of working capital required for future periods.

Sources of Working Capital

(1) Bank sources – Commercial banks are the most important source of providing short-term finance. The different forms of providing short-term finance by the banks are as follows:

  • Cash credits – Cash credit is an arrangement under which the borrower is allowed to withdraw money from the bank up to a certain limit. The limit is determined by the bank on the basis of borrower’s financial position and credit worthiness or security deposited by the borrower. The borrower can repay the amount, partially or fully, as and when he desires. Interest is charged only on the amount actually withdrawn by the borrower. However, a minimum charge may be payable to the bank for availing this facility.
  • Overdrafts – It is a temporary arrangement in which a customer operating current account with a bank is allowed by the bank to overdraw money upto a certain limit. Generally, this overdraft facility is provided for very short-term like one week or fortnight. Overdraft limit is determined by the bank and the borrower can overdraw upto the limit without completing any formality. Interest is charged by the bank on the actual amount overdrawn by the customer and rate of interest charged is little higher as compared to term loans. It is the simplest and convenient source of finance to meet the working capital requirements.
  • Discounting of bills – It is a form of advance provided by the bank to the holder of the bill before its maturity date after deducting discount. The bank presents the bill to the acceptor of the bill on the maturity date and gets its payment. If the bill is dishonoured on the maturity date, the total amount is recovered from the customer who had availed this facility of discounting the bill.
  • Letters of credit – A letter of credit is an arrangement where a bank helps its customers to obtain credit from its suppliers. When a bank issues a letter of credit in favour of its customers for some specific purchases, the bank undertakes the responsibility to honour the obligation of its customer in case of default.

(2) Non-bank Sources – These sources of finance include the following:

  • Trade credit – Trade credit represents the credit usually allowed by suppliers to their customers according to trade customs. If the payment for purchasing goods is not made immediately, it becomes a short-term finance. Amount of trade credit depends upon the credit worthiness of an enterprise.
  • Commercial papers – Commercial paper is an unsecured money market instrument issued in the form of a promissory note. Corporate having tangible net worth minimum of 4 crore can issue commercial papers (CPs). CPs can be issued in denominations of 5 lakh or multiples thereof for a period ranging between 7 days to one year.
  • Advances from customers – Some businessmen demand advance money from their customers at the time of accepting their orders. Such an advance may be fixed percentage of amount of the order. Such advances are adjusted at the time of payment of full price of the goods. No interest is paid on such advance by the businessman.
  • Accrued expenses – Expenses which have been incurred but have not become due for payment, are called accrued expenses. Wages and salaries are usually paid in the month next to the month in which the services were rendered. Similarly, interest is paid periodically whereas the principal amount is used continuously. Likewise, the tax is paid periodically much after earning of profits. Therefore, the time-lag in the payment of accrued expenses is considered as a short-term source of finance.
  • Factoring – Factoring is a business activity in which a financial intermediary takes over the responsibility of collecting a firm’s receivables. In other words, a factor is a financial institution which offers services relating to management and financing of debts arising from credit sales. The factor advances 70 to 80 percent money to the entrepreneur against receivables and charges interest at rate higher than the lending rate of commercial banks. The balance amount is paid by the factor to the entrepreneur on due date after deducting cost of factoring. Thus, factoring is considered as a short- bow term source of finance.
  • Short-term loans from Financial institutions – It is an advance of a fixed amount from a financial institution and sanctioned for a fixed term. Interest is charged on the total amount of loan and rate of interest is usually lower as compared to cash credit and overdraft. The total loan amount with interest is paid by the businessman on due date.

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