Financing of Current Assets

Net working capital is the excess of current assets over and above the current liabilities. From the above definition the reader can conclude that a part of the current assets are financed by a source other than the current liabilities. This source is long term finance. The sources of long term finance are discussed in article. Now we will discuss various short term sources of finance that may be employed to finance current assets. These sources are:

1. Spontaneous liabilities
2. Trade credit
3. Short term bank finance
4. Public deposits
5. Inter-corporate deposits
6. Short term financial assistance from financial institutions
7. Commercial paper

Spontaneous Liabilities:

This includes (1) Accruals and (2) Provisions

Accruals are liabilities covering expenses incurred on and prior to a specified date, payable at some future date. For example, if a company is following a policy of paying wages for every wage once per month. With the change in policy the firm is deferring the payment of wages for three weeks. Thus, amount of accrued wages increases because of deferring the wage payments.

Provisions are changes for an estimated expense. These provisions do not involve immediate cash outflow. Cash outflow occurs when the actual amount of liability is known and paid for. Examples for provisions are provisions for dividends, provision for taxes etc.

These spontaneous liabilities constitute a very small fraction of the current liabilities, thus usefulness of this source to finance current assets is very limited.

Trade Credit:

Trade credit is the credit extended by the supplier of goods and services. Trade credit is an important source for financing current assets. On an average, trade credit accounts for nearly 40 percent of current liabilities. The suppliers generally extend credit based on the financial soundness of the buyer and the relations between them.

Bank Finance:

The major source for financing current assets is bank finance. The various ways in which the banks finance current assets are:

(1) Loan arrangement
(2) Overdraft arrangement
(3) Cash credit arrangement
(4) Bills purchased and bills discounted
(5) Letter of credit
(6) Note lending system

Loan arrangement: Under this arrangement banks credit the entire loan amount to the borrowers account. In case the loan is repaid in installments, interest is payable on actual balance outstanding.

Overdraft arrangement: Under this arrangement the borrower is allowed to overdraw on his current account with the bank up to a stipulated amount. Within this limit the borrower is allowed to make any number of drawings. The borrower can make repayments whenever desired during the period. The interest liability of the borrower is determined on the basis of the actual amount utilized.

Cash credit arrangement: Cash credit arrangement is similar to the overdraft arrangement. In this arrangement borrower can draw up to a stipulated limit based on the security margin. This type of arrangement holds good only when the working capital (fund based) requirements of the borrower is very large to the tune of a minimum of Rs 1 crore and the cash credit is usually allowed against pledge or hypothecation of goods. Unlike the overdraft arrangement, in cash credit arrangement the borrower has to pay 1 % as commitment charges on the unutilized balance during the period.

Bills purchased and bills discounted: Under this arrangement a banker purchases or discounts the bills generated during the credit sales of goods. When a bill is purchased or discounted by a banker, the amount provided is usually covered by the cash credit and overdraft limit. Before discounting the bill the bank satisfies itself about the credit worthiness of the drawer (i.e. seller of the goods) and genuineness of the bill.

Letter of credit: Under this arrangement banks help its customers to obtain credit from his suppliers. According to this, a bank opens a letter of credit in favor of the supplier i.e one who sends material to the customer of the bank. Because of this arrangement if the customer of the bank fails to meet the payment obligations, then the bank is liable to pay the amount on the due date.

Public Deposits: The deposits mobilized from public by non-financial manufacturing companies are known as public deposits or fixed deposits.

Inter-corporate Deposits: Under this arrangement one company makes a deposit with another company, normally for a period above six months. For example, Firm ‘A’ deposited an amount of Rs 5 lakhs for a period of 6 months in Firm ‘B’. This is referred as inter-corporate deposit.